Smart-beta funds: How to pick and choose?

Instead of the regular index, where the highest weight is given to the stock with the largest market capitalization, the smart-beta index gives the highest weight to the stock that scores the highest on the specific factor.

At the Mint Money Festival 2024, which took place on 22 November in Mumbai, Siddharth Srivastava, head ETF-product and fund manager, Mirae Asset Mutual Fund, explained how smart-beta funds work and can help investors during different phases of the market.

Factors and cycles

Markets go through different phases, and each factor tends to respond differently to different market phases.

“Before the global financial crisis, the best-performing factors were alpha and value. During the global financial crisis, the best-performing factor was low volatility. In 2014, alpha did well. Then, around the time of covid-19 outbreak, the best factor was quality. During market recovery, value was the top-performing factor,” Srivastava said.

In 2007, the alpha factor delivered 91.8% returns, while the value factor delivered 109% returns before the 2008 financial crisis.

Momentum and alpha factors capture companies with stronger recent performance; the value factor captures companies trading at a lower price in relation to fundamental value; the low-volatility factor looks for companies with lower-than-average volatility; and the quality factor looks for companies with stable earnings growth.

These factors don’t necessarily follow any diversified strategy. “Different factors aim to capture different market trends. For example, momentum and alpha factors follow trend-investing. So, these factors are unbiased about stock concentration or sector concentration. If the capital goods sector is doing well, it will invest in capital goods; if healthcare is doing well, it will invest in healthcare. It is good for people looking for high-risk, high-return investment options,” Srivastava added.

For example, the low-volatility factor is likely to do well when markets are in the bearish phase, as it picks stocks that have shown the tendency to fall less when markets fall.

But then, these stocks are likely to underperform when markets are rallying. This is because these stocks tend to have market beta of less than 1. A beta of 1 means the index will move exactly in tandem with markets, less than 1 means it would fall less when markets fall, as well as rise less when markets rise.

How to pick

“Typically, defensive investors can consider low-volatility and quality factor funds, while aggressive investors could consider momentum or alpha funds. Since different smart beta funds do well in different phases and market cycles, it may be a good idea to consider a combination of both market-cap-weighted index funds and multi-factor smart-beta funds in a portfolio,” said Vishal Dhawan, founder of Plan Ahead Wealth Advisors.

However, smart-beta funds should be considered after careful analysis and comparison.

“Study long-term behaviours of these funds versus passive index strategies as well as active strategies in the same universe. Studying and comparing rolling returns, along with sharpe ratios, will be a good starting point,” said Kavitha Menon, founder of Probitus Wealth. Sharpe ratios measure risk-adjusted returns or returns generated against per unit of risk taken by the fund.

As mentioned earlier, the factors don’t necessarily follow rules of diversification across sectors or stocks, hence one option is to mix and match different smart-beta strategies to create diversification.

“A basket of different smart-beta funds that have negative or little correlation is also a good idea, as it offers diversification and would help offset the portfolio’s performance when one factor underperforms the other,” she added.

For example, a combination of alpha and low-volatility factors has outperformed large- and mid-cap funds in recent and historical periods, according to a Mirae Asset analysis.

In the 10-year period, the multi-factor strategy delivered 18.8% annualized returns versus 16.4% returns delivered by large- and mid-cap funds. In the five-year period, it delivered 23.8% returns versus 16.4% delivered by large- and mid-cap funds. In the three-year period, it delivered 20.3% returns versus 18.9% returns delivered by large- and mid-cap funds.

Diversifying

Smart-beta funds fall between actives and passives. These are not fully passive as these funds don’t just track the market-cap-weighted indices like the Nifty 50 or the Nifty 500—where companies with the largest market cap get the largest weight—and not fully active as the indices include or exclude stocks based on the factor-based filters designed by the fund house and index providers.

Hence, smart-beta funds can be combined with a portfolio of actively managed funds or passively managed funds to incorporate a differentiated strategy in the portfolio.

A multi-factor smart-beta fund or a combination of negatively or less correlated smart-beta funds can help reduce the risk of a single-factor fund, which may underperform when market conditions don’t support that factor.