Keeping pace with terminology in the world of investing can be daunting for most investors, so before we dive right in, let’s spare a few moments to grasp the backdrop and context that have led to the emergence of the term ‘smart beta’, after a quick look at what it is.
In a nutshell, smart beta sits at the intersection of active and passive investing. While active investing is an ideology that advocates cherry picking and monitoring investments, passive investing most commonly involves investing in a portfolio of securities that replicates an index, without trying to take advantage of ‘mispricing’. For those unfamiliar with these terms, the following sections should help.
While both – active and passive – approaches have their merits, they also have drawbacks, and to understand this in a bit more detail, let’s start with active investing, the older and more traditional style of investing, with a focus on mutual funds in India.
The reality of active investing – it’s a mixed bag
While both – active and passive – approaches have their merits, they also have drawbacks, and to understand this in a bit more detail, let’s start with active investing, the older and more traditional style of investing, with a focus on mutual funds in India.
Late last year, The Economic Times quoted Dhirendra Kumar, CEO, Value Research, as saying “Largecap funds are no longer relevant”. Coming from the man, who is a veteran and long-time advocate of mutual fund investing in India (and one of the few advisors newbie retail investors could turn to), this seemed to be the first sign that a trend commonly observed in the US (active investments underperforming passive investments) was reaching Indian shores. Confirming the suspicion, Mr. Kumar discussed stats that are rather disconcerting for retail investors:
“When I look at the SIP return of the largecap funds, I am not looking at point to point return. There are 71 of them and over the past five years despite doing the SIP, only 14 are able to beat the index. Over the last 10 years, of the 41 funds that exist, only 11 beat the index. So it is hard. Largecap funds have lost the ground. They are no longer relevant. If you have to invest in largecaps, consider the ETF”
Data from S&P Dow Jones Indices in its SPIVA scorecard shows that about 40% of actively managed largecap and tax-saving mutual funds outperformed their benchmarks over a 5- and 10-year time frame, while the number stood at about 60% and 45% for small and midcap funds over the past 5 and 10 years, respectively.
Playing devil’s advocate – End of the road for actively managed funds? Probably not
While this may leave a lot of us disillusioned (and there's no arguing with a credible voice of reason like Mr. Kumar), it’s important to note that this data is as of the end of 2018, which was a particularly bad year for small and midcaps, as well as a forgettable year for largecaps at large, with a handful of stocks propelling the Nifty50 and Sensex, and the latter up ca. 6% in 2018. Quoting from a recent report:
“A historical look at the monthly return of this index suggests that the year 2018 has seen the second highest number of months recording negative returns after a gap of seven years in 2011”
So, perhaps this may not be the data based on which to sound the death knell for active investing. It’s likely that a larger proportion (than indicated by this data set) of funds manage to beat market returns during decent years, which means it could boil down to the ability to pick the right funds. And while funds may not beat their benchmarks every year, the question is, do they still outdo the other options available to investors over a longish period of time?
If that is indeed the case, one might still want to consider such funds if they do outperform their benchmarks more frequently than indicated by the data presented earlier. Besides, with the SEBI curbing mutual funds’ fees, funds are bound to stack up better in the coming days.
Further, one could argue that phases such as this – where indices such as the Sensex and the Nifty50 are kissing record highs while there are several pockets that are still battered (think housing finance companies, the auto sector, etc.) – could represent a window for opportunistic investing.
Last but not the least, we still don’t have small and midcap index funds in India. All put together, it may be safe to say that at least for the time being, there’s still a place for actively managed funds.
Passive funds – A perfect solution, but only in an imperfect world?
The combination of simplicity, transparency, diversification and low costs makes passive investing – which most commonly involves mirroring an index – a mouth-watering proposition. However, if it were perfect in itself, wouldn’t we just do away with active investing altogether? The fact is that for passive investing to thrive or even survive, it needs active investing.
Imagine a scenario where everybody chose to invest only in passive funds – how would that impact returns? In such a scenario, returns would merely become a function of fund flows, at best, or the result illiquid markets, at worst.
Besides, replicating indices has some obvious disadvantages. Most index funds implicitly replicate the market cap-based weights that govern indices in India. What that means is that your investments will be allocated based on the proportion/weight of companies in the index you’re replicating, rather than return potential.
For instance, if you replicated the Sensex today, you would probably end up putting most of your money in Reliance Industries, which has rallied for the past year, simply because it’s the largest Sensex component, and less of it in a company like Maruti Suzuki, which has actually fallen sharply this year. If you’re thinking a few years ahead, that might not necessarily be the best way to go about it from a returns perspective.
Interestingly, if index funds do what they are supposed to, which is to replicate the returns generated by their underlying indices, they would, by definition, underperform the index post fees, however small the fee may be. And that is precisely why it may be meaningful to look at the degree by which actively managed funds underperform indices in years when they do, rather than merely looking at whether they underperform or outperform them.
In all fairness though, given that active funds are likely to continue to exist, passive funds are great options for investors who lack the time, knowledge or resources to actively manage their investments – especially given the debate around whether active funds actually outperform benchmark indices in the long run. Further, the low charges imply that they cost way less than most actively managed funds. And that’s probably why ETFs have grown to account for close to 20% of total assets in US mutual funds and exchange-traded funds as of 2017, rising from negligible levels in 2000.
Smart beta – A middle ground
The issues that come with active and passive investing have led to the emergence of smart beta, which aims to combine the best of both worlds.
As opposed to using market capitalisation as the basis for the allocation of funds within a basket of stocks – as is commonly the case with index funds – smart beta allows investors to base the allocation on other factors, such as valuation metrics and dividend yields (dividend per share divided by price per share), among others. Some of the most commonly used factors are volatility, momentum, quality, size, value and dividend yield. Smart beta funds can also be based on themes, such as rural economy, consumption, housing, etc.
Constructed the right way, what you get is a product that comes with greater transparency and lower costs (and subjectivity) when compared to conventional active investing while still allowing investors to leverage and utilise pricing anomalies and value investing opportunities, among others.
Understandably, smart beta funds have gathered interest and AUM over the years. According to FT.com, assets under management in smart beta funds grew to USD1.13trn as of September 2018. That said, the opportunities in the Indian context remain very limited.
As of December end last year, there were 9 schemes run by traditional mutual fund industry players. That apart, smart beta options are offered by a handful of non-traditional players (mostly fintech start-ups).
Smart beta – A cure for all ills?
Smart beta combines the virtues of active and passive investing and could go a long way in democratising the investing landscape for retail investors, an under-served section of the investing community. However, it’s not necessarily as bulletproof as it appears to be.
First of all, some of these products could get quite complex, and returns are only as good as the underlying rules and themes (the stock picking for themes could also get subjective at times) they are based on. Further, the fact that they are not actively managed means that you could potentially be sitting on ticking time bombs (think Vakrangee, DHFL, Yes Bank, Jet Airways, etc.), partly because there isn’t a quantitative measure for corporate governance.
Further, it may be more suitable for investors who are able to evaluate the merit of themes, as well as understand when to enter and exit them – the housing finance debacle late last year comes to mind. While actively managed funds may also have been hit, at least investors in such funds had someone better equipped than themselves to handle the situation. So, it’s not merely risk appetite but also awareness levels that come into play for those who want to invest in smart beta.
Additionally, since the majority of such products are designed based on the back-testing of rules that govern them (to see which combination of rules would give the best results if they were implemented x number of years ago), they are based on investing environments of the past and are not necessarily the best when faced with unprecedented circumstances (think trade wars, big-bang reforms, regulatory changes, etc., which could alter the landscape significantly).
Last but not the least, given that smart beta ideas can be thematic, the resulting products could carry risks akin to those with thematic funds, which is considerably higher than the risk that comes with simple index investing. To sum up, smart beta products are not necessarily the mass-market products they are often made out to be. All in all, smart beta could be a good additional option (but not necessarily replacements for active and passive investing options) for the more sophisticated investor.
Disclaimer: I am a newbie in the stock market (even after close to a decade), but then markets are such that everybody always is -- predictions do go horribly wrong. Investments in stocks/bonds/investment products do not come with any guaranteed returns. I may or may not hold positions in any of the stocks/products mentioned in this post, and my opinions could be biased. I am not a qualified investment advisor. The content in this post only reflects my personal opinion and should not be treated as investment advice. Readers are advised to carry out their own due diligence and consult their investment advisors to understand the risks involved in any investment. Trading in stocks/shares/bonds or any other products carries the risk of monetary loss.
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