Smart Beta Funds: Are They The Right Choice?

Adopting a middle-of-the-road approach, Smart Beta funds combine the aspects of reliability and creativity to offer investors profitable returns. They aim to outperform the traditional market indices without the unpredictability of active management. The article defines the functionality of Smart Beta funds and how investors can use them for a better risk-return strategy [EasyDNNnews:PaidContentStart]

I magine you are at a buffet, and you have two choices. On one side, there’s a fixed menu: the same dishes every day, in the same proportions, just like a standard index fund that tracks the market without deviation. It’s reliable, predictable and cost-effective, but sometimes it might not cater to your exact taste or dietary needs. On the other side, there’s a skilled chef offering personalised meals, adjusting flavours, ingredients and portions based on what he believes will bring out the best flavours. 

This is akin to actively managed funds—potentially more rewarding but at a higher cost and risk, depending on the chef’s (in our case, the fund manager) skills. Now, imagine a third option: a buffet that adjusts its offerings based on data-driven insights about what guests have enjoyed the most in the past. It combines the reliability of the fixed menu with some of the creativity and potential reward of the chef’s personalised touch. This third option changes not based on the chef’s whims but on a set of transparent, rule-based criteria. 

This would be akin to choosing dishes that are consistently popular among the diners. This, in a nutshell, is what Smart Beta funds are like. Smart Beta funds take a middle-ground approach. They are a specialised category of passive funds that replicate or track strategy indices, often referred to as Smart Beta indices. Unlike traditional passive funds, which simply mirror broad market indices, Smart Beta funds utilise specific strategies to enhance returns and manage risk. 

They use a set of defined rules—such as favouring stocks that have shown strong past performance (momentum), stocks that are undervalued (value), or those with lower price volatility to construct their portfolios. They aim to outperform the traditional market indices without the unpredictability of active management. Just like that optimised buffet referred to above, Smart Beta funds strive to offer investors the best of both worlds, blending the systematic approach of passive investing with the strategic potential of active management. 

The average performance of such funds has been better than the broader market performance in all the recent timeframes. This performance should be taken with pinch of salt as these Smart Beta funds are not uniform in style. Nonetheless, on an average they have outperformed the Nifty 500 over the past six months, one year, two years and three years. In the Indian market, several such strategy indices are available, catering to diverse investor needs and preferences. 

Working of Smart Beta Funds
Continuing with the buffet analogy, Smart Beta funds are like having a curated menu prepared by a nutritionist who uses specific rules to pick the healthiest and tastiest dishes for you. Rather than just opting for the most popular items (as a traditional index fund might), these funds use a more thoughtful approach, selecting ingredients based on particular qualities that are believed to enhance your health or taste experience. In the world of investing, these ‘ingredients’ are the factors that Smart Beta funds focus on. 

Overview of Methodology
At the core of Smart Beta funds is a rule-based, systematic approach to stock selection. Unlike traditional index funds, which simply weigh stocks based on their free float market capitalisation (i.e. the larger the company, the bigger its presence in the fund), Smart Beta funds use specific criteria to choose and weigh stocks. These criteria, or ‘factors’, are based on research or empirical data that suggest how certain characteristics can lead to better risk-adjusted returns. The process begins with a set of rules—think of them as the recipes for the menu. 

These rules dictate which stocks make it into the fund and how much of each stock to include. For example, a Smart Beta fund focused on value might have a rule that only includes companies with a low price-to-earnings ratio, low price-to-book value and higher dividend yield, which historically indicates that they may be undervalued. Another fund might prioritise stocks that exhibit low volatility, meaning their prices don’t fluctuate wildly, which can be appealing to risk-averse investors. 

Some of the most popular strategies and their outcome are indicated below: 

Common Factors Used in Smart Beta Funds
Smart Beta funds often focus on specific factors that academic research and industry experience suggest are linked to superior long-term performance. Here are some of the most commonly used factors. The following table gives you a glimpse of various factors their characteristics and how are they defined. 

This rule-based approach has several advantages:
1. Transparency: Investors know exactly what criteria are being used to select stocks, eliminating the unpredictability that can come with active management decisions.
2. Consistency: The rules are applied consistently, which reduces emotional decision-making and biases that can impact returns.
3. Cost Efficiency: While Smart Beta funds may have higher expenses than traditional index funds due to their more complex strategies, they are still generally cheaper than actively managed funds because they follow a set algorithm, reducing the need for constant management oversight. 

Combining Factors for a Multi-Factor Approach 

Many Smart Beta funds use a combination of these factors to create a diversified portfolio that balances risk and return. This multi-factor approach seeks to harness the benefits of different factors while mitigating the risks associated with relying on a single factor. A fund or ETF might blend low volatility and dividend yield strategies to provide steady income and reduce risk or combine value and momentum factors to capture potential gains from undervalued stocks that are beginning to gain market attention. 

Although we do not have a fund tracing this index, Nifty Alpha Quality Value Low-Volatility 30 is a multi-factor fund which intends to capture the long-term risk premia by diversification across four factors: alpha, quality, low volatility and value. By doing so, it intends to counter the cyclicality of single factor index strategy and provides investors a choice to take exposure to multiple factors through a single index product. The index consists of 30 stocks selected from Nifty 100 and Nifty Mid-Cap 50. 

Potential for Better Risk Returns 

One of the primary appeals of Smart Beta funds is their potential to generate higher returns compared to traditional marketcapitalisation-weighted index funds. In the above paragraph, we have seen how Smart Beta funds have outperformed the broader equity market in different timeframes. This advantage stems from their use of factor-based strategies that are designed to capitalise on specific market inefficiencies. By selecting and weighting stocks based on attributes such as value, momentum or quality, Smart Beta funds aim to exploit these inefficiencies for superior performance. 

For instance, value-based Smart Beta funds invest in undervalued stocks that are poised to appreciate as their true worth is recognised by the market. Similarly, momentum-based strategies can capture gains from stocks with strong recent performance trends, benefiting from the market’s inertia. Studies have shown that certain factors, like value and momentum, have historically delivered excess returns over long periods. This is because they leverage behavioural biases in the market, such as investors’ overreactions or underreactions to news, which can lead to mispricing. 

By systematically applying these factor-based strategies, Smart Beta funds offer a disciplined approach to capturing alpha (market outperformance), which may not be as readily achievable through traditional market-capitalisation-weighted indexing. While no investment is guaranteed to outperform, the targeted selection and weighting of Smart Beta funds provide a structured way to seek higher returns over the long term. To understand the risk and return profile of these factors, we carried out a detail study of the indices as we do not have much historical data on Smart Beta funds. 

The following graph clearly shows the performance of the different factors. It is clearly visible that Nifty 500 has generated lower return in the long run. 

Maximum Drawdown Chart of Different Indices 

The following table goes beyond the annualised returns to reveal the character of each factor. 

Based on the data provided in the above table, all the strategies have outperformed Nifty 500 in terms of total return, with alpha and momentum showing the most significant outperformance. Quality and low volatility also provide better returns than Nifty 500, but to a lesser extent. Value has the lowest outperformance among these strategies. In terms of risk. low volatility and quality strategies show lower maximum drawdowns compared to Nifty 500, indicating better downside protection. Alpha and momentum, despite their higher returns, come with higher maximum drawdowns, suggesting higher risk. 

When we combine both risk and return to get a better understanding of the risk return profile through Calmer ratio, we find that the low volatility strategy has the highest Calmar ratio, indicating the best risk-adjusted return among all the strategies. Quality and momentum also have higher Calmar ratios compared to Nifty 500, suggesting better risk-adjusted returns. Alpha and value have slightly higher Calmar ratios than Nifty 500, indicating a moderate improvement in riskadjusted returns. 

In summary, alpha and momentum strategies offer the highest returns but come with higher risk. This is reflected in their higher maximum drawdowns and average drawdowns. Quality and low volatility strategies provide a good balance between risk and return, with higher CAGRs and lower drawdowns compared to Nifty 500. The value strategy, while slightly outperforming Nifty 500 in terms of return, has higher associated risks, making it less attractive on a risk-adjusted basis. 

Low volatility stands out as the best strategy in terms of risk-adjusted returns (highest Calmar ratio), making it a preferred choice for risk-averse investors. By diversifying across multiple factors, these indices can help reduce the risk associated with investing in any single factor or sector. For example, while a traditional market-capitalisation-weighted index might be overly concentrated in Large-Cap stocks and vulnerable to downturns in a few major companies, a Smart Beta fund using a multi-factor approach can spread its exposure across value, quality and low volatility stocks, thereby mitigating the impact of adverse market conditions on any one factor. 

Choosing the Right Smart Beta
Fund When considering Smart Beta funds, a crucial step for investors is to evaluate factor exposure—essentially, understanding how different factors align with their personal risk tolerance and investment objectives. Smart Beta funds utilise various factors discussed above and each of them cater to distinct investor needs and market scenarios. Selecting the right factor exposure is akin to customising a portfolio that resonates with one’s financial goals and risk appetite. 

For aggressive investors aiming for higher returns, factors like alpha and momentum are often appealing. These factors thrive on capturing significant price movements and market inefficiencies. Alpha strategies seek to generate returns beyond the market average by focusing on stocks that are expected to outperform due to specific characteristics or mispricing. Momentum strategies, on the other hand, look to capitalise on the continuation of existing market trends, investing in stocks that have recently demonstrated strong performance. 

While these strategies offer the potential for substantial gains, they also come with higher risk. Stocks chosen based on momentum or alpha factors can be more volatile and sensitive to market swings, which might lead to larger drawdowns during market corrections or downturns, as indicated in the table above. Conversely, for more conservative investors who prioritise a stable return over maximising gains, factors like low volatility and quality are more suitable. Low volatility strategies target stocks with relatively stable price movements, which can help mitigate the overall risk of the portfolio. 

This factor exposure is particularly beneficial during periods of market turbulence or economic uncertainty, as it helps to reduce the fluctuations in portfolio value, providing a smoother investment journey. Quality-focused strategies invest in companies with strong financial health, including stable earnings, low debt levels and high profitability. These companies are typically more resilient to economic downturns, offering a balanced approach to risk and return. Evaluating factor exposure also involves considering market conditions and economic outlooks. 

For example, during bullish markets where growth stocks and high momentum are driving forces, momentum and alpha strategies may outperform. However, in bearish or volatile market environments, low volatility and quality factors tend to provide a safety net by offering more consistent and predictable returns. Investors should not only align their factor exposure with their personal risk preferences but also remain adaptable, ready to adjust their strategies in response to shifting market dynamics. 

Conclusion
Smart Beta funds offer a sophisticated, data-driven approach to investing, sitting between the simplicity of traditional index funds and the potential for higher returns offered by active management. By systematically applying well-researched factors, these funds aim to deliver better risk-adjusted returns while maintaining transparency and cost effectiveness. Whether or not Smart Beta funds are a good fit for an investor depends on their individual risk tolerance, investment goals, and understanding of the underlying factors driving these innovative investment products. 

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