For now, smart-beta investing is a small space in India with little investor interest. But it could grow big in the coming years. Its selling proposition — a combination of passive and active investing — could potentially deliver the best of both — good returns at low cost.
A smart-beta fund is a form of passive fund that mirrors a curated smart-beta index. A smart-beta index, developed by index providers such as NSE, chooses stocks from a parent index based on pre-defined parameters. For instance, the Nifty100 Low Volatility 30 TRI chooses 30 low-volatility stocks from the Nifty 100 index.
The curation of the index using pre-defined parameters such as alpha, value, quality, low volatility and equal weights also gives it an active hue. Smart-beta investing is also called factor-investing as the index is filtered on the basis of factors — one (single-factor) or more (multi-factor).
Currently, there are nine smart-beta funds with a total corpus of just about ₹325 crore. Most of the schemes have a limited track record, and their performance is a mixed bag.
Multi-factor differentiator
A new, open-ended smart beta fund — ICICI Prudential Alpha Low Vol 30 ETF (exchnage-traded fund) — has now been launched, its new fund offer (NFO) open from August 3 to August 10. It is a multi-factor scheme unlike the others in the market that are single-factor funds. So, ICICI Prudential Alpha Low Vol 30 ETF will track the Nifty Alpha Low Volatility 30 Index and provide exposure to a portfolio of stocks selected based on a combination of two factors — alpha and low volatility.
The Nifty Alpha Low Volatility 30 Index consists of 30 stocks selected from the Nifty 100 and the Nifty Midcap 50. So, the fund, too, will consist of these 30 curated stocks from a list of 150, based on their alpha-generation and low-volatility metrics over a one-year period.
While alpha generally is understood as the excess returns of a stock/fund over the market or benchmark, in this case, the alpha is Jensen’s alpha — that takes into account the excess return relative to the risk taken. Standard deviation is used as the measure of volatility. The index is re-balanced every six months; the fund will also follow this.
The new scheme, with two factors, intends to counter the cyclicality of the single-factor index strategy. Chintan Haria, Head - Product Development and Strategy at ICICI Prudential Mutual Fund, says the single-factor strategy can have extreme outcomes at times — doing very well when the factor is preferred by the market and languishing when it is out of favour. A multi-factor strategy has an automatic hedging mechanism, lower performance swings, and can avoid extremes.
The Nifty Alpha Low Volatility 30 Index has equal weights (50 per cent each) to Jensen’s alpha and to low-volatility factors. So, a fund that draws on this index is a bet on a top combination of growth and stable stocks from various sectors.
As of June 30, 2020, the Nifty Apha Low Volatility 30 Index has top allocation to the consumer goods and pharma sectors, with Nestlé India, Dr. Reddy’s Laboratories, Divi’s Laboratories, Dabur India and Colgate Palmolive (India) being the top stock holdings. There is a 5 per cent cap on exposure to a single stock in the fund, reducing concentration risk.
Back-testing results
As per back-tested data by the fund house, the Nifty Alpha Low Volatility TRI outperformed indices such as the Nifty 100 TRI, the S&P BSE 500 TRI and the Nifty 50 TRI in eight out of the 10 years until 2019, and over the long run. It also did relatively well on a risk-adjusted returns and five-year rolling return basis.
Note though that past performance is not an indicator of future performance. Also, as with all index funds and ETFs, there will be some difference (tracking error) in the returns of the index and the scheme.
The fund manager, Kayzad Eghlim, also manages the two other smart-beta funds from the fund house — ICICI Prudential Nifty Low Vol 30 ETF and ICICI Prudential NV20 ETF. Like other ETFs, the units of the NFO will be listed on NSE and BSE where investors can buy or sell.
Often, low liquidity on the exchanges results in the quoted prices of an ETF being at variance with the fund’s net asset value (NAV). Haria says the fund has appointed authorised participants to provide liquidity on the exchanges, and based on rules, investors can approach the fund house, too, if need be, for liquidity.
The fund seems different from the existing products in the market. Investors seeking a rule-based, low-cost approach to investing in stocks that could offer alpha-plus-low volatility can consider buying the fund. The expense ratio of the fund is expected to be 40 basis points (0.4 percentage points).
It is imperative though that investors have a long-term horizon and an understanding of the product. It may be a good idea to start small and test the waters on the liquidity aspect before committing more money. Since it is an ETF, investors will need a demat account to transact.