Do you need smart beta funds in your portfolio?

By Kaustubh Belapurkar |  17-03-21 | 

Passive funds are making inroads in India. Index funds and Exchange Traded Funds, or ETFs, collectively manage assets worth Rs 2.73 lakh crore as on February 2021. A majority of this asset base consists of traditional passive funds which mirror the underlying benchmark. In the recent past, we are seeing a new breed of passive funds which bring active element in passive investing, which are called smart beta funds. Such type of funds are already popular in developed markets.

Let’s look at what they are and how they function. Let’s begin with the traditional passive funds. The plain vanilla passive funds track indices which are made up of market capitalisation weighted indices. Market capitalisation is derived by multiplying the share price with number of outstanding stocks. Companies which have a higher market capitalisation tend to have a higher weightage in the index and the movement of few large companies in the indices can swing the index. Firms with smaller market capitalisation will not significantly contribute in the index movement due to their small size. If the index has 50 stocks, then a traditional passive fund will mirror the underlying constituents of the index in exactly the same proportion as the stock weights. Such indices are popular around the world and India is no different.

On the other end of the spectrum, active managers will try to actively manage the holdings within this 50 stock index to outperform the benchmark. They will go overweight or underweight on the stocks represented in the index unlike passive funds which will replicate the index as it is.

Within the passive funds space, there are equal weighted index funds. For instance, Reliance Industries Limited holds 10.77%, the highest weight in Nifty 50 Index. An equal weight smart beta fund will give 2% weightage to RIL in Nifty 50 Equal Weight Index. The smart beta fund will hold 2% each in the 50 stocks which form part of Nifty 50 Index. This is the simplest form of smart beta fund. It marries the elements of active and passive investing.

There are other types of smart beta funds which apply factor investing. There are seven factors which are accepted globally. They are the drivers of risk and return in the market.

  1. Size: Large, mid and small caps.
  2. Style: Value and growth.
  3. Quality: Top companies or leaders in the segment.
  4. Volatility: Standard deviation of the returns of stocks.
  5. Momentum: Pick stocks that have done well in the past.
  6. Dividend Yield: Dividend that a company pays relative to its share price.
  7. Liquidity: Trading volume or the ability to buy and sell the stock.

In India, smart beta funds follow one of the above listed factors while investing. Let’s take the example of quality. From the universe of 100 stocks, you will rank companies based on parameters like return on equity, low debt to equity ratio, earnings per share, and so on. You will pick the best 20-30 stocks based on these filters to form an exchange traded fund.

For most investors, I would recommend sticking to actively managed funds and regular ETFs. Another good way of taking exposure to the market is through equal weighted smart beta funds which don’t focus on any one single factor. Experienced investors may want to take exposure to certain stocks through specific factor-based ETFs of their choice.

Excerpts from CNBC TV interview. Watch the full interview here.

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