Mutual Funds: A Quick Take on Smart Beta Index Funds

Smart beta funds, as a mutual fund category, have been gaining ground at a steady pace in the past few years. 

Typically, a smart beta index fund operates as a passive investment tool. It usually tracks an index that selects stocks using a specific strategy. These indices draw stocks from broader benchmark indices such as the Nifty 50, Nifty 100, or Nifty 200. 

Generally, they employ criteria such as low volatility, quality metrics (for example, return on equity, debt-equity ratio, earnings per share ratio), momentum, and dividend yield, to list a few. 

A few Asset Management Companies (AMCs) or fund houses have steadily introduced smart beta funds in the past few years. As of February 13, there are about 56 smart beta funds (across exchange-traded and index funds) that manage assets worth Rs 15,996 crore, as per a report. 

The success of a smart beta fund relies on how smartly the underlying index has been constructed so that it correctly captures a forthcoming trend. For example, the Nifty 50 Value 20 (NV20) index. Of the 50 stocks that lie in Nifty, the NV20 index curates just 20 stocks that, as per its methodology, appear as value picks. 

The National Stock Exchange (NSE)  introduces such niche indices that are curated out of mainstream, regular, existing indices, on which AMCs benchmark their smart beta funds and anticipate to outperform an index fund or Exchange-Traded Funds (ETFs) that would otherwise pick all stocks, priced attractively or unattractively, in a broader index.

As far as understanding the workings of the smart index fund is concerned, it is important to remain patient while waiting for the scheme’s strategy to perform. The past one-three years have remained favourable for one or the other smart-beta strategies.

It is important to note that smart beta funds will not outperform in all markets, and there will be challenging times. In certain years, only a few stocks tend to perform well. During such times, an equal-weight index might not work. The way indices, at times, react is out of an individual’s control.

Smart beta indices showcase notably different portfolio compositions as compared to broader indices. For example, the Nifty Midcap 150 Momentum 50 Index holds about 19% of its stocks in the healthcare sector, a considerable contrast to about 11%  weight in the Nifty Midcap 150 Index. 

In addition, financials represent about 21% of the Midcap Momentum Index, significantly higher than the 12% allocation in the Midcap 150 Index. This divergence is related to the strategy’s focus on selecting stocks demonstrating relative outperformance. 

As a result, sectors such as healthcare and Public Sector Unit (PSU) financials, which have recently highlighted a strong performance, carry higher weightage in the Mid-cap Momentum Index, contributing to its outperformance relative to the broader market-cap-based Mid-cap 150 index.

However, their limited appeal and understanding have contributed towards most of these funds remaining of modest size. Of the 52 funds in this group, about three schemes have breached the Rs 1,000-crore mark. 

Experts think that with the penetration of demat (dematerialised) accounts, ETFs are likely to gain popularity. In addition, many mutual funds have now begun introducing either index funds or a Fund-of-Funds (FoFs) version to existing smart beta ETFs.

Notably, new investors would do well to stay away from smart beta funds for now. This is until these categories of mutual funds go through market cycles and highlight the robustness of their underlying benchmark indices. 

However, in case an investor has a well-established portfolio and does not want fund managers’ risk, they can allocate a small portion in smart beta funds, depending on which index’s strategy they prefer. It is not passive investing in the strictest sense. This can be rewarding if an investor acts with patience.