Low cost passive funds such as Exchange Traded Funds (ETFs) and index funds are fast gaining popularity with retail investors. ETFs are a type of mutual fund schemes that are listed and traded on a stock exchange just like stocks. Buying and selling of ETFs is as simple as buying/selling of any other stock on the exchange. Thus with ETFs, one can benefit both from the flexibility of a stock as well as diversification of an open-ended mutual fund scheme.
Typically, the expenses related to an ETF is very low and returns mirror that of its underlying index minus expenses. However, even within the passive universe, there are ETFs which offer an element of active management when it comes to the underlying portfolio. These types of offerings are known as smart beta ETFs.
What is a smart beta ETF?
Smart beta ETF, also known as factor based ETF is a cross-over category of rule-based investing strategy, which combines principles of active management with a passive approach to provide better risk-adjusted returns. Here, a fund manager follows an index based on certain sacrosanct rules, while making investment decisions, thereby the philosophy of investment remains passive, but the style of investment becomes rule-based as they target specific factors or investment strategies, hence, active. The factors here can be value, growth, momentum, low volatility, quality and several other factors for creating a portfolio.
Since the entire process is rule-based, there is no room for human bias while making investment decisions. The underlying index of a factor-based product is actively managed, based on the factor chosen. The underlying index is not static and gets reviewed semi-annually to keep up with the evolving market conditions. This means investors need not worry about rebalancing. Past data reveals that over long-term, factor-based strategies have delivered a positive investment experience.
Single factor or multi factor?
When it comes to smart beta indexes, they could be put together based on a single factor like momentum, value etc. or a combination of factor/multi-factor like alpha and low volatility. For example, if the factor chosen is low volatility,then the Nifty 100 Low Volatility 30 index tracks the performance of 30 stocks in Nifty 100 with the lowest volatility in the last one year.
On the other hand, a multifactor ETF targets more than one attribute, making them a more diversified approach to factor investing. For example, if the factors chosen are alpha and low volatility, then the Nifty Alpha Low Volatility 30 index comprises stocks selected based on the top combination of these two factors chosen from the Nifty 100 and Nifty Midcap 50 universe. So, depending on one’s portfolio requirement, an investor can choose between a single-factor or multifactor ETF to invest in.
Popular factors in domestic market
Value: The value factor is based on the premise that inexpensive stocks relative to their fundamental value have historically outperformed stocks with higher valuations over the long run. The companies here are selected on the basis of Return on Capital Employed, Price-Earnings, Price to Book Value and Dividend yield.
Momentum: The momentum factor favours stocks with stronger relative performance, with the expectation that this price momentum will persist.
Low-volatility: Here, stocks with the lowest volatility in the last one year from a predefined universe is chosen. It can be measured using standard deviation and beta.
Quality: This strategy identifies companies with durable business models resulting in sustained growth. Quality score is calculated on the basis of Return on equity (ROE), Debt equity ratio (D/E) and average change in EPS.
Alpha: From a predefined universe, stocks with the high alpha over the last one year are chosen in this factor.
Investor take
The objective of smart beta ETFs is to deliver enhanced risk-adjusted returns by focusing on specific factors which aim to exploit market inefficiencies that may lead to outperformance over time. The allocation to these should be considered as a part of one’s equity allocation. Investors can choose smart beta ETFs that align with their investment objectives.
For example, if an investor is of the view that value stocks are undervalued compared to other styles, then such an investor may choose a value-oriented smart beta ETF that selects and weights securities based on value factors. Similarly, investors seeking lower volatility may choose a low volatility smart beta ETF that emphasises stocks with lower historical price volatility.
While at it, remember that like any other investment, smart beta ETFs too have their own set of risks. Investors should carefully evaluate the underlying holdings of smart beta ETFs before investing, and consider their own risk tolerance and investment objectives.
Chintan Haria, Head Investment Strategy at ICICI Prudential Asset Management Company Limited
