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The smarter way to index investing

Smart beta ETFs are the culmination of the investor's search for funds with low costs and potentially high returns

The smarter way to index investing

For long, mutual fund investors in India have had to make do with a devil-or-deep-sea choice. If they wanted good returns, they had to shell out the higher fees charged by active equity funds (2.5 to 3 per cent a year). If they were frugal about costs, they had to settle for Exchange Traded Funds (ETFs) tracking the CNX Nifty or the S&P BSE Sensex that deliver far lower returns.

But a new alternative is now emerging in the form of Smart Beta ETFs, which have just made a start in India. A little background is necessary to understand how they solve the problem.

Big difference
No matter how cost-conscious you are, it is difficult to sweep aside the fact that, in India, active managers deliver. The best active fund managers here, unlike those in the US, have trounced Sensex and Nifty-tracking ETFs by convincing margins over the last 3, 5 and 10 years, after charging their annual fees. Even considering just Large-cap equity funds, the best performing ones have earned a 23-30 per cent CAGR in the last 3 years while Sensex/Nifty ETFs have delivered 15-17 per cent. For 5 years, top active funds served up a 16-20 per cent CAGR while index ETF returns are 11-12 per cent. In 10 years, the best funds got you to a 14-16 per cent return while the index ETFs, at 9-10 per cent, struggled to get to the double-digits.

Advocates of index investing will argue that identifying the best active funds is a difficult task. That past performance is no indicator of the future. But the truth is that investing in actively managed funds has paid off in a big way for most Indian investors. You need not actually own the best funds. Even middle-of-the-road active funds have managed to deliver better long-term returns than Sensex or Nifty tracking ETFs.

The key reason for this lies in the composition of bellwether indices. When the exchanges construct benchmark indices such as the Sensex or the Nifty, their intention is to capture the largest, most liquid and actively traded stocks in the market. It is certainly not to identify the most fundamentally sound businesses for investors to own for the long-term. As a result, investing in the Sensex and Nifty ETFs makes you own the biggest stocks in the market, but certainly not the best ones from a fundamental perspective.

In the last few years, for instance, as an ETF investor you would have ended up holding on to commodity majors like Hindalco and Coal India through the worst of the commodity meltdown, or PSUs like BHEL when earnings steadily lost momentum. Few active fund managers would have done this.

Enter Smart Beta
Well, global investors who are even more Scrooge-ish about costs, have found a neat solution to this dilemma. They are taking to ETFs that use 'smart beta' or 'factor investing'.

The term Beta, in investing parlance usually denotes the tendency to move with the market. What Smart Beta ETFs essentially do is to mimic 'smart' indices, custom-built to suit fundamental investors, rather than the 'dumb' market-cap or liquidity based indices that are created merely to reflect market activity.

So how do these 'smart' indices choose their constituents? Well, they may use a variety of other fundamental, technical or other filters to choose their constituents. A Smart Beta ETF for a fundamental investor may filter stocks for earnings growth, valuation multiples, dividend record, return on equity or free cash flows. A very popular category of Smart Beta ETFs, of late, are Low Volatility ETFs, which look for companies with historically low volatility in earnings/dividends and stocks with low volatility (standard deviation) in price. This mode of investing is also called 'factor investing' because it relies on identifying the key factors that drive stock selection and then using them to build portfolios.

In short, these ETFs try to identify the precise quantitative factors that active fund managers use to select stocks. They then use computer programs to automate that selection process. They construct an index using the same factors and build portfolios to mirror that index. While Smart Beta products have been around for over a decade in the global context, they have attracted significant flows from institutional investors in the last few years only.

While Smart Beta ETFs charge more in management fees than plain vanilla index ETFs, they are far cheaper than actively managed funds because they don't need to employ expensive star fund managers or large research teams. Once the Smart Beta strategy is identified, the index is rejigged at periodic intervals on autopilot. The ETF simply ploughs money into the index on an as-is-where-is basis.

Already in India
Global developments in the world of investing usually take ages to come to India. But the good news is that Smart Beta ETFs have already made their debut. Apart from ETFs tracking the Shariah indices (which is really a Smart Beta strategy) which have been around for some time, Smart Beta ETFs from fund houses such as Edelweiss, Reliance (both under R*Shares and Goldman Sachs), ICICI Prudential and Kotak have been rolled out in the last one year.

These products mainly piggyback on a series of strategy and thematic indices flagged off by the NSE and BSE in the last couple of years. Therefore, R*Shares, ICICI Pru and Kotak AMC have ETFs mirroring the NSE's NV20 index, a benchmark made up of twenty bluechip 'value' stocks from the Nifty. Edelweiss has an ETF tracking the NSE's Quality 30, an index that filters the best companies from the top 100 based on return on equity, earnings CAGR for 3 years, Z score, low debt-equity ratio and so on. And R*Shares runs an ETF mirroring the CNX Dividend Opportunities Index too.

Pluses and minuses
A big plus, for cost-conscious investors is of course the low likely fees of Smart Beta ETFs. While the expense ratios for many of these funds aren't available yet, the few Smart Beta ETFs that have disclosed their fees peg them at 0.30-0.50 per cent a year. This may be far higher than the less than 0.10 per cent fee now charged by many Sensex/Nifty ETFs, but is surely more economical than the 2.5 to 3 per cent charged by active equity funds. This could make a significant difference to returns in the long run.

Two, given that Smart Beta strategies rely on a process and well-set quantitative filters, investors need not worry about star fund managers exiting the scheme, triggering style changes and this in turn decimating the fund's performance record. Given that Indian fund houses experience quite a bit if manager churn, this is a live risk out of the way.

But there are minuses to Smart Beta strategies too. Despite their fancy moniker, Smart Beta funds, at their heart are not very different from thematic investing. Value stocks, Quality stocks or Dividend Yield stocks may all perform in one market cycle, and fail in another. In an active equity fund, you can expect the fund manager to make the necessary switches in style/strategy to still deliver returns (especially as style etc are not very fixed in India). But with Smart Beta strategies, it would be up to you to make these calls, as the fund is essentially on autopilot.

Whether or not this new category of funds takes off, though, there is one clear benefit for mutual fund investors in general. The active fund managers, who have so far found benchmarks like the Nifty and Sensex quite easy to beat, may have a far harder time measuring up to their new smart rivals. This may keep them on their toes.

This column appeared in the October 2016 Issue of Mutual Fund Insight.