Are smart beta funds really smart enough?

Recently we have seen a lot of index funds/ETFs getting launched and it does include smart beta funds as well. Read on to understand whether it is worth your attention.

Since the market is witnessing a rally, we have seen a plethora of New Fund Offers (NFO) getting launched. In fact, even the index funds and Exchange Traded Funds were launched to take advantage of the rally. Among these passive investments, there were few smart-beta funds too. Though, smart beta is not new to us as the first smart beta fund was launched in June 2015 - Nippon India ETF NV 20. This ETF tracks the Nifty 50 Value Total Returns Index (TRI). Kotak too was not behind in the race as it launched its Kotak NV 20 ETF in December 2015 which was quite similar to Nippon India ETF NV 20.  

Defining smart-beta funds  

Smart-beta funds adopt a strategy-based approach and invest based on factors such as value, quality, momentum, low volatility, high beta, etc. There are two kinds of factor-based approaches. One is single factor-based investing, wherein only one factor such as alpha, low volatility, momentum, etc is considered while selecting stocks. Another type is multi factor-based investing, here a combination of factors such as alpha-low volatility, quality-momentum, alpha-low volatility-momentum, etc is considered while selecting stocks.  

How smart-beta funds are different from quant funds?  

Quant funds mostly have adopted multi factor-based investing approach while building their portfolio. Additionally, quant funds have their own rules of switching between these factors. Moreover, few of them also use AI and machine learning capabilities to build and rebalance their portfolio. However, there is a thin line between smart beta funds and quant funds. Smart-beta funds using multi factor-based approach does not switch their allocation depending upon rules. The allocations are fixed and the only thing they do is to rebalance it periodically to restore the pre-determined allocation.  

Performance of smart-beta strategy  

In order to gauge the performance of the smart beta strategy, we would be looking at the performance of respective smart beta indices. 

As we can see from the above graph, it is only Nifty 500 Value 50 TRI and Nifty High Beta 50 TRI that gave negative median returns. Interestingly, it only gave negative returns on a one-year rolling returns basis, but stood positive on three-year, five-year and seven-year rolling returns basis. All other smart beta indices gave positive returns in all the time frames. Except for Nifty 500 Value 50 TRI (for one-year and seven-year median rolling returns) and Nifty High Beta 50 TRI, all other indices gave double-digit returns in all the time frames. If we look at it from a returns perspective, it has indeed generated phenomenal returns. However, one should not invest just based on returns.  

Let us now head towards understanding the risk undertaken by these smart beta indices. 

The above table shows how these smart beta indices are fair in terms of risk statistics. We have purposefully added the risk metrics of Nifty 50 TRI to get an idea about the risk undertaken by these indices. Barring a few, such as quality, low volatility and multi-factor smart beta indices containing the low volatility and quality, the rest others are comparatively taking higher risk than Nifty 50 TRI.  

Surprisingly, looking at risk from the perspective of maximum drawdown, then Nifty 200 Momentum 30 TRI scores over Nifty 50 TRI. The worst performer, in this case, is Nifty 500 Value 50 TRI and Nifty High Beta 50 TRI. Their drawdowns are quite scary. 

Here is the list of the top smart beta funds that are currently available to invest in. 

Should you invest in them? 

Looking at their performance with respect to risk as well as returns, it does look quite good. However, this should not form part of your core portfolio. This can be considered from a diversification perspective of your satellite portfolio. Further, do not allocate these funds to your financial goals especially to those that are needed for a child’s education, retirement, etc. The rationale behind the same is that they are high on risk. Having said that, it is quite evident that the performance of Nifty 500 Value 50 TRI and Nifty High Beta 50 TRI is not encouraging both in terms of risk as well as returns. Therefore, it would be prudent to avoid any index funds or ETFs that seek to track these indices.