Globally, smart-beta funds have taken the investing arena by storm and have already garnered $1.12 trillion worth of investments globally by March 2021, according to ETFGI’s Smart Beta industry landscape report. While the scale and size of these products in the developed markets are gaining heft, these funds have also made their way to India as well. A smart beta fund seeks to combine the benefits of passive and active investing strategies. The goal is to obtain a relatively higher alpha while keeping the costs lower than traditional investment options.
What is a Smart Beta offering?
Beta is a measure of market volatility represented by an index. It becomes a ‘smart’ beta when the allocation of an index is tweaked to achieve a better risk-reward ratio. Long-term data indicated that single-factor based index strategies, could exhibit cyclicality and may underperform during certain market phases. An alternative smart beta strategy is to select stocks based on a combination of multiple factors, as a means to counter the impact of the cyclicality of single-factor indices. Today, most of the products available in the smart beta space revolve around the following four factors – low volatility (lower variation in price), Value (stocks relatively cheaper), Quality (consistent growth irrespective of the business cycle) and Momentum (following the trend).
Globally, with interest rates in the developed markets remaining abysmally low, the smart beta index based on dividend yield has been the main factor in drawing significant investors’ attention. Meanwhile, in India smart beta strategies around low volatility, value and a combination of alpha and low volatility have attracted reasonable investor interest.
So how do these schemes work?
Each of these indices being rule based eliminates human bias while making investment decisions. For the sake of explanation let us consider two examples – a single factor and a multi factor ETF. For the single factor offering let us consider the largest smart beta fund –
Prudential Nifty Low Vol 30 ETF. As the name suggests the scheme is a single factor offering based on low volatility. Here, the aim is to invest in a portfolio of 30 least volatile stocks from the Nifty 100 universe. Additionally, the weightages of the stocks in the index are also based on their volatility. As this is an ETF, the offering will replicate the Nifty 100 Low Volatility 30 Index.
Now coming to multi factor offering, the product under consideration is the ICICI Prudential Alpha Low Vol 30 ETF. As the name suggests, the portfolio of stocks selected here will be based on two factors- Alpha and Low Volatility. The portfolio will consist of 30 stocks selected from Nifty 100 and Nifty Midcap 50. Here, through a single ETF, an investor gets the opportunity to take exposure to multiple factors.. Further, it will also aid in countering the cyclicity of single factor index strategy. The underlying index here is the Nifty Alpha Low Volatility 30.
To conclude, if you are an investor looking to build a diversified portfolio, then smart beta funds which are low cost in nature can prove to be very helpful. Depending on one’s investment comfort and given the long investment tenure in case of a millennial investor, smart beta ETFs can help generate better risk-adjusted returns.
(The author is the Head- Product Development & Strategy, ICICI Prudential AMC.)