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Is it Time for Smart Beta Funds?

Mar 13, 2019
5 mins | Views 3769

Like sea waves and the sea, fluctuations and markets go hand in hand. While equity investors have to live with stock market volatility, investors need to devise ways to consistently grow their money too. For mutual fund investors, a possible route for thriving even in volatile markets could be “Smart Beta Funds”. If you want to know more about them¸ read on.

Active and passive funds - Your money in mutual funds can be invested according to two broad approaches. The first involves fund managers shaping their own investment strategies and executing them. This is the active investment approach. Mutual funds could also follow an index and invest in securities, typically stocks, in the same proportion as the index. This is passive investing approach. A fund manager practising active fund management tries to provide better the results from a passive approach and get for the investor, a significant additional return, or “alpha”.

Passive or index investing involves lower costs compared to active investing due to lower fund management costs since index funds and exchange traded funds (ETFs) mimic the underlying index and adopt a “buy-and-hold” strategy. The lower costs mean that a greater portion of your money’s growth reaches you. This is supplemented by lower costs due to lower portfolio turnover compared to the active approach.

In volatile markets, these features of passive investing can make a significant difference to the investor. At the same time, in passive investing, you lose out on the expertise of the fund manager possibly delivering a kicker in returns. Of course, there is a catch. You can never be certain which fund will provide the outperformance and how much of it will benefit you after accounting for the costs.

In this backdrop, the question arises as to whether there is a middle path between active and passive investment. This is where “smart beta funds” come in. They are devised as a halfway house between active and passive investing in mutual funds.

Smart Beta Funds Up close - Smart Beta Funds typically follow smart beta strategies that typically involve things like taking a standard index and tweaking it. Or, it could be taking a different index to generate returns higher than a passive investment approach. The indices can be based on a host of factors such as price of securities and fundamentals, and not just the traditional market capitalisation based approach.

The basis of making a choice of a different index or tweaking an existing one can help in many ways. First, it can provide a better quality of diversification. For instance, if the underlying index has lesser number of cyclical stocks, it typically makes the investments less volatile. At the same time, during market rallies, their ability to switch to a higher growth gear is limited.

Smart Beta Funds involve more than just mirroring the underlying index hence they incur relatively higher expenses as compared to index funds due to a higher portfolio turnover. However, these charges are typically lower than actively managed funds.

ETFs and its variants like Smart Beta Funds have gained huge global acceptance, especially in the West, after global financial crisis of 2008* when fund managers struggled to deliver fund outperformance. In India, there have been many outperforming actively managed funds over different time periods. Thus, Smart Beta Funds could be used as a volatility combating investment in India.

The critical part about investing in Smart Beta Funds is to understand the underlying index or the “factor” guiding the investments. The latter is about the rules that govern the investments made by the fund manager. Investors, who can understand them and find them a useful addition to their existing investments, can take advantage of Smart Beta Funds.

*Source: https://www.cnbc.com/2018/09/14/the-trillion-dollar-etf-boom-triggered-by-the-financial-crisis.html

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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