Smart beta funds outshine large-cap funds category

In the market fall since February 19, large-cap funds as a category have lost about 26 per cent. But many smart beta funds which invest in select large-cap stocks from the Nifty 50 or Nifty 100 basket have contained losses much better, dipping only by 18-21 per cent.

A smart beta fund is a form of passive fund that mirrors a curated smart beta index. A smart beta index chooses stocks from a parent index based on certain pre-defined financial parameters.

Superior returns

Over the long term, some smart beta indices such as Nifty 100 Low Volatility 30 TRI (low vol 30) and Nifty 50 Value 20 TRI (NV 20) have outperformed their parent indices such as the Nifty 100 TRI and Nifty 50 TRI as well as the average returns of large-cap funds.

There are currently nine smart beta funds (three index funds and six ETFs) in India based on strategies such as equal weight, value, low volatility and quality. With the concept of smart beta being nascent in India, most funds in this category have only a one to three-year history. However, the good show put up by the underlying indices of some of these funds over longer time-frames signifies that taking exposure to the smart beta category may pay off for investors.

Over one-, three- and five-year periods, the low vol 30 and NV 20 indices have outdone the returns of their parent indices and the average returns of large-cap funds by one to seven percentage points (see table). The former chooses 30 stocks from the Nifty 100 basket with the least swing in prices in the last year (measured in terms of standard deviation of the daily price return). The value 20 strategy filters 20 stocks with low price-to-earnings, low price-to-book, high return on capital employed and high dividend yield from the Nifty 50 basket.

Says Chintan Haria, Head – Product Development & Strategy at ICICI Prudential Mutual Fund, “By virtue of the filters applied in the low vol 30 and NV 20 strategies, majority of the stocks selected are large-cap and quality names. These stocks have gone up in the last few years, benefiting the funds based on these strategies.”

Not all strategies have worked though. Equal weight funds — which attribute equal weights to all stocks of an index — have languished. But these funds cannot be written off. Says Anil Ghelani, Senior V-P and Head of Passive Investments & Products, DSP Investment Managers, “We have done back testing for the Nifty 50 equal weight TRI and in situations where there is polarisation in the market, equal weight will always underperform, as was the case in the last three years or so. But in the 2008 downspin, the Nifty 50 Equal Weight TRI contained losses better than the Nifty 50 TRI. In 2009, which was a more participative rally, the strategy performed better than Nifty 50 TRI.”

Case for passive investing

Apart from superior returns, smart beta funds are also characterised by low tracking error and expense ratios. Expense ratios of smart beta funds range from 0.1 to 1 per cent, much lower than active funds, whose charges go up to 2.7 per cent. However, considering that smart beta options suit more sophisticated investors, the corpus of these funds remain negligible. Liquidity and price discovery of smart beta ETFs thus raise some concern.

However, Chintan Haria says, “Passive investing is gaining popularity in India. The liquidity of ETFs improve when investor participation increases, leading to better price discovery. As an AMC (asset management company), we try our best to ensure through our authorised participants that the quoted price of the ETF is close to the net asset value.”

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