Passive investment started as an idea to provide market exposure to investors at a low cost by replicating indices like S&P 500, Nifty 50 etc. Even though it is a simplistic idea, passive investment changed the landscape of the investment industry.

But over time, voices grew that passive investment is too mundane as it simply replicates and captures market behaviour and is not nuanced enough to target a certain risk-return profile and a certain behaviour, which can only be achieved via active fund.

To address this requirement, smart beta investing was conceptualized to bridge the gap with active investment by applying well established factors used in active investment in a rule-based framework of passive investment.

In smart beta indexing, stocks are selected and weighted in a portfolio based on factors such as quality, value, momentum, low volatility, equal size etc. instead purely on free float market capitalization.

Thus, while HDFC and Reliance are top 2 securities in any plain vanilla index also capturing large caps like Nifty 100, Nifty 500 etc, a momentum based product on Nifty 100, may exclude these 2 securities altogether or assign much lower weightage, if these 2 stocks are exhibiting poor momentum.

Hence, like active funds, smart beta indices are using multiple parameters to cherry pick the right stocks for a concerned product objective.Thus, like active funds, smart beta indices may have completely different sets of stock exposure as well as sector exposure. This exposure may change as stocks behaviour changes with regards to a certain factor. For example, Nifty 200 or Nifty 50 have highest sector allocation to financials in recent times, whereas Nifty 100 Volatility 30 has highest allocation to FMCG and Nifty 200 Momentum 30 to Capital goods.

Hence, depending upon objective and stock behaviour, smart beta indices carry a different stock and sectoral exposures which may evolve over time especially in case of alpha strategy.

Active fund managers may have a growth style or a value style or may chase momentum or seek portfolio stability and attract investors whose investment objective aligns with fund objective.

Like these funds, smart beta exhibits cyclicality and may perform differently in different market cycles. For example, at the time of distress in the market or during global turmoil, low volatility and quality factors tend to do well relatively.

During the economic boom or bull market phase, momentum & value (especially in recovery) generally tends to do well. In the long run, intent is to generate superior returns or target superior return-risk profile.

Another interesting data which captures the activeness of smart beta indices (funds) is the active share of the portfolio. Based on Feb end data, it is fascinating to note that smart beta products like Nifty 100 Low Volatility 30 has around 61% active share whereas Nifty 200 Alpha 30 has as high as 89%.

Comparatively, the average active share of Top 10 large cap funds is just 39%. Data suggest that active funds may be more benchmark hugging than the passive smart beta funds!

Smart Beta 1ETMarkets.com

Again, when it comes to portfolio churn, Nifty 200 Alpha 30, A 30 stock portfolio, has a one sided churn of 27 stocks, which will give a fair competition to active funds.

As intended, since smart beta strategies tend to target a certain risk return profile, the investor should be able to choose one which aligns with their goals, like in case of active equity funds.

While smart beta products like momentum and value have worked well recently, they may underperform broad based products for longer periods than anticipated in certain market cycles.

This risk cannot be completely mitigated but can be subsidized by investing in more than one smart-beta fund with opposing characteristics or investing for a longer horizon which helps in tackling the cyclicity.

For example, if we look at calendar year performance, we can see that Nifty 200 Alpha 30 has done well when markets were doing well i.e. 2023, 2021, 2017, 2014. Low volatility and quality on other hand did better in 2018, 2011, 2010 when markets were negative or flattish.

Having said that, while low vol underperformed in 2019, and marginally in 2021 and 2022, over a longer horizon, which captures market cycles, it has generated excess returns (2% in the last 10 years) and excess risk adjusted returns over benchmark.

Smart Beta 2ETMarkets.com

In India, we have 57 smart beta passive products with an AUM of Rs 16,798 Cr. We now even have a few multi factor – based products also. The exact allocation would depend on the investor’s goal along with risk appetite.

It will also depend if the investor is trying to create a core portfolio with smart beta products or is using them in satellite portfolio by taking tactical calls.

One strategy, which is being used by advisors and money managers is to use a combination of factors products like Low Vol plus Alpha instead of investing in Nifty 50 or Nifty 100.

Having said that, smart-beta funds are not a replacement for regular broad-based passive funds or active funds. These are very effective options to target a certain risk and return profile and segment/style which may be missing in your portfolio. It should be used by investors only if they understand the nuances of these factors.

Apart from historical backtesting, some of these indices now have been LIVE for over 10 years and there is enough data which back the utility of these products in investor portfolio, but investors should be ready to observe the activeness in portfolio and performance of these passive products.

(The author is Head – ETF Product and Fund Manager, Mirae Asset Investment Managers (India))

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)


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