When you invest in ‘actively’ managed funds, mutual fund houses appoint fund managers to manage them. They aim to beat the market based on their ability to select and time the investments. However, investors in such funds also face the risk of earning lesser money than that of the market – if the fund underperforms. 

At the other end of the spectrum are index funds that are ‘passively’ managed by only tracking the market indices. It reduces the risk of underperformance and matches market returns.

Is there a middle ground? That’s what smart beta funds position themselves to be. It claims to offer the benefit of passive investing combined with some of the advantages of the active ones. It hopes to maximize returns for investors or reduce risk through scientific construction of portfolio.

How do they work?

These funds essentially follow a traditional popular index – Nifty 50 or Nifty 100. However, it tags along a rule-based system for selecting stocks into the portfolio which in turn might exhibit certain metrics or behaviours. 

Some are intuitively appealing. For instance, it could be equal-weighted index as against the usual free-float market-capitalisation weighted indices of national stock exchanges. The traditional indices have a tendency to give higher weightage (or share) in the index to stocks that have already had a run up in its prices. 

This is because market capitalisation is a function of price (stock price x outstanding shares). So, you might end up buying stocks when they are high and not lower. 

In contrast, equal-weighted index of Nifty 50, invests no more than two percent in each of the 50 stocks. So, profits get booked automatically as stock prices rise beyond a point. 

Similarly, there are funds that curate stocks from the traditional indices based on stock’s fundamentals, quality and price volatility. Multiple filters such as earnings growth, price-to-earning ratio or volatility are applied to shortlist a portfolio that fits the fund’s mandate. 

Are these funds really smart?

Costs

There are many smart indices launched by the stock exchanges and smart beta funds passively track them. While some are available as Exchange Traded Funds (ETFs) and traded in the stock exchanges, others could be purchased from the mutual funds as a fund-of-fund. Fund-of-fund structure essentially takes care of two issues – poor liquidity in ETFs and the need to have a trading account. 

Usually, the annual expense ratios of smart beta funds are lower than actively managed funds (2-2.5 percent). Among the smart beta funds, ETFs have the lowest expense ratios in the range of 0.2-0.4 percent, while it is about 1 percent for fund-of-funds.

While smart beta funds have a long history in developed markets. In India, it is not so. In the last one year, none of the funds managed to beat its respective benchmark. DSP Equal Nifty 50 Fund (regular) gave a return of -14.1 percent as against -13.3 for its benchmark.

Track Record

While smart beta funds have a long history in developed markets. In India, it is not so. In the last one year, none of the funds managed to beat its respective benchmark. DSP Equal Nifty 50 Fund (regular) gave a return of -14.1 percent as against -13.3 for its benchmark. While some experts peddle back-tested data to prove supremacy of smart beta funds, it is prudent to wait for at least one market cycle to check its real smartness. 

Efficient Market still ahead

While Indian equity markets are getting efficient, fund managers still have a role to play. More than 50 percent of large-cap equity funds managed to outperform S&P BSE 100 TRI (Total return Index) in the last five years. There is still scope for earning higher returns than the market by prudently picking good-performing equity funds. 

Jury Not Out

Moreover, these funds ought not to be your core portfolio. They don’t promise to do well under all market conditions. While some outperform during secular bull markets, others do well in a bear phase. With no long-term history of its actual performance, retails investors are advised to cool their heels, till the jury is out.