Smart-beta funds are gradually gaining a foothold in India. Recently, ICICI Prudential Mutual Fund launched its Alpha Low Volatility 30 Exchange Traded Fund (ETF). Several such funds already exist, based on themes like equal weight, quality, low volatility, and so on. These funds have been around for only a short period–only a couple have a five-year track record.
Let us first get a perspective on what led to the development and launch of these funds in the developed markets of the West. As those markets turned more efficient, it became harder for fund managers to beat their benchmarks. Money flowed from actively managed funds (where fund houses typically charge a higher expense ratio) into low-cost passive funds. To stem this flow, fund houses thought of a midway solution—a category of fund where there would be no fund manager but where the choice of the portfolio would not be entirely passive. These funds were priced higher than passive funds but lower than active funds.
Next, let us turn to how a smart-beta index is developed. Suppose that you invest in an index like the S&P BSE 500. In such an index fund, the return you get is akin to that of the entire market (we may call this return beta). But suppose you take this index and fine-tune it, by applying some criteria or filters, which you think will either enhance its return. When you develop an index by doing this, it is called a smart-beta index.
Some of these smart-beta indices are based on a single criterion while some are based on two. The latter are referred to as multiple-factor indexes.
The goal of these funds or ETFs, as said, is to offer returns that are superior to that of a pure passive fund. But we know that higher returns are always accompanied by higher risks. Investors need to be cognizant of the risks they are taking when they invest in a smart-beta fund.
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