Mutual funds are using smart beta strategies to increase returns in index funds

What is beta?

Beta is a tool that measures stocks volatility. In other words, Beta represents stock volatility with respect to the market. E.g. if the beta of stock A is 2 i.e. the stock volatility is twice of the market volatility. It means stock A is twice riskier than the market and with a 1% move in the market stock A is likely to move 2%.

What is Smart beta?

Smart beta investing is a combination of passive & active investing. The goal of smart beta is to obtain lower risk or increase diversification at a cost lower than traditional active management and marginally higher than straight index investing. It seeks the most optimally diversified portfolio construction.

What are ETFs?

Over the years, ETFs have become quite popular in Indian markets. They are regarded as an alternative to investing in the index (Nifty 50, Sensex), which generally represents the broader market. ETF in simple words is the basket of securities replicating an index. They are considered safe bets when compared to investing in individual stocks as ETFs are diversified.

Since ETFs are passively managed investments; it is difficult to generate an excess return over the market index. This is where smart beta funds come into play. These funds are relatively new to the Indian markets, but they have established a strong presence in developed markets. Smart beta strategies attempt to increase investor returns while keeping risk to a minimum. This is one way to invest in blue chip stocks with a smart weighting strategy which is known as Strategic beta investing, smart beta or factor-based funds.

What is driving the interest in Smart Beta Funds?

In recent years, the poor performance of actively managed mutual funds has pushed investors to their low-cost, passively managed, index-tracking counterparts, such as exchange-traded funds (ETFs) and index funds worldwide. In turn, the inability of traditional ETFs and index funds to outperform their benchmark is likely the most important factor attracting investor interest in smart-beta funds.

How mutual funds are using smart beta strategies?

Smart beta funds are factored indices - that is why these are also called factor funds. The fund manager replicates an index but due to certain investment restrictions, a complete replica becomes difficult.

Mutual funds using the smart beta on the following parameters:

As the investment style is rule-based, it is not completely passive. According to March 2021 report, smart-beta funds had received $1.12 trillion in global investments. Index funds are managed by simulating the performance of a stock market index. Most indices are based on market capitalization, but in recent years, there has been an escalation of factor-based smart beta indices. This is how smart beta strategies help MFs to make an investment in large caps funds with unbiased stock selection and low expense ratios.

Thank you.

Regards,

Ritika Toshniwal,

Kautilya,

IBS Mumbai.