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The Mutual Fund Show: Should You Invest In A Smart Beta Fund?

As stock markets evolve, so do the methods or ways to invest in them. A smart beta fund, often powered by computer algorithms, combines the benefits of passive and active investing by applying investment strategies based on market-cap weights.

“One of the important factors is that it eliminates human bias,” Anil Ghelani, CFA, senior vice president and head of passive investments and products, DSP Investment Managers said on BloombergQuint’s weekly series, The Mutual Fund Show.

“While actively managed funds will continue to do well in the large-cap space in particular, it’s becoming increasingly difficult for fund managers to outperform the benchmark compared with the past,” he said.

Watch the full interaction here:

Here are the edited excerpts from the interview:

Is it a good time to take exposure in banking and BFSI funds?

Kalpen Parekh: Few months back there was a lot of cynicism around banking because of the liquidity crises and banks, NBFCs went through significant amount of volatility. So, this is the reversion to mean trade which plays out. This happens every time whenever there is a sharp correction in a certain sector some reversion to mean would happen. In our view, the banking and financial services is roughly one-third of the benchmark by weight. If an investor says that if a benchmark has one-third weight in this space and if I am investing in active funds which also has one third weight then the choice of stocks may be different, but I want to exercise a much larger conviction and have a larger exposure of banking and financials in my portfolio. Then for a hypothesis like that it could make sense to be in a banking and financial services fund. Fundamentally, the hypothesis here is that as the economy formalises and grows, then finance is the lifeline. So, good companies which are providing finance and are well managed from a risk point of view will continue to do well. In finance, typically in banking, you have Re 1 of equity and Rs 5-10 of leverage and debt and then that gets deployed. If the lending is good, then your return on equity can be better. Every few years we have these types of sharp fluctuations. It is always good to invest in good companies when the headlines are negative.

Jack Bogle, the founder of Vanguard, said smart beta is the big new thing. I wouldn’t quite say that it was stupid, but it makes claims that are beyond its ability to fill. Why are we talking about smart beta?

Anil Ghelani: There are different angles to it. If we try to simplify smart beta in a very basic way, if you look at the risk and return of any stock, you can break it down into six to eight factors. An interplay between these factors and packaging of that is something you can define as smart beta. In January, we saw the marathon. Suppose somebody is preparing for marathon and you have been given a diet that you need to have ‘X’ component of carbohydrates, ‘Y’ component of proteins, then once you get the diet you don’t look at what food you are eating but slice through it and make sure that by the end of the day that much quantity of carbohydrates, proteins are eaten. Similarly, in smart beta if you decide that you need ‘X’ quantum of growth, ‘Y’ quantum of momentum, so much lower quantity of volatility then you don’t look through any other aspect but make sure that portfolio gets these factors in the proportion you want and a product which packages this in the quantity and manner in which you want would be defined as a smart beta. If you look at it from a global context, smart beta products are very popular. In Indian context, they are starting to pick up now. The simplest form of smart beta is equal weight. We did an equal weight product a year-and-a-half ago on the Nifty. So, we did Nifty equal weight as the simplest form of smart beta and we offered it to investors in India. We will now gradually go to the next stage. We are working on creating a new product which will have three factors which are combined together as a product.

Why do investors need smart beta product in their portfolio?

Kalpen Parekh: There are passive funds which give the returns of market called beta. If the market goes up by Rs 100, you get Rs 100— which is the beta of market. Then there are active funds which have largely been the mainstay of the Indian mutual fund for the past two decades which says that if the market gives Rs 100, we will give Rs 103-105 which is my intent and over the last 20 years, that intent has largely been shown which is through the generation of alpha. You have passives on one side which gives you the beta of the market, and then you have active funds which largely make money. If beta of a market is 12 percent and active fund has generated 14 percent, so 12 percent is the market return itself and 2 percent extra is your active alpha. Smart beta asks what are the drivers of the excess return of active fund manager? If there are successful active fund managers in India or around the world, there are few principles which they have followed consistently. These are called factors. You try to extract the source of extra alpha. For some fund managers, the source of alpha could be buying good companies at cheap prices. So, valuation is a factor. So, fund managers buy growth companies, so high growth rate is a factor. For some fund managers, just focusing on quality of business and high return on capital companies is a factor. So, there are 12 factors around the world. At its core three factors largely contribute to most of that excess alpha—quality, growth and valuation. If you are able to extract these sources and that is what most successful managers in India have demonstrated as their alpha.

How does one do it?

Kalpen Parekh: For instance, the Nifty which is the largest benchmark with 50 companies. These will have companies across sectors and will have different parameters. So, there will be many companies with high RoCs but there will be few companies with low RoCs, too. There will be many companies which will be very expensive, moderately expensive and cheap. If I want to build a smart beta on Nifty, I only want to take the high RoC slice. Lot of corporate banks currently would be going through low RoEs. Smart beta products, which is designed around high RoEs, will exclude these companies. So the index will exclude companies which are below a certain threshold of RoEs if my defining factor is quality, and that is generally defined through RoEs and RoCs. It will have a filter.

Let’s say it filters companies with more than 15 percent RoEs and above. Then, from the index you eliminate companies which are lower than this RoE and only choose ones which are above that parameter or threshold. From the passive product, you are eliminating what you don’t like as a fundamental principle and you are choosing what you like. Out of the 50 stocks, you end up choosing 30. But those 50 stocks will have certain weights because they are 50 but now you have only 30 stocks. So, the weights will get realigned. For example, HDFC Bank is 9 percent in the 50 stocks and now the stock universe has become 30, so the 9 percent weight will increase to may be 11 or 12 percent. So, what you like, you are allocating more capital towards it and what you like is a function of your belief. So, multiple smart beta ideas will have unique beliefs. I may have the belief that I want to only buy the cheapest company from this range of quality. So, you can optimise for valuation after you have taken a slice of quality and growth. So, you are trying to do is what are the sources of long-term excess return that an active fund manager has always used, and you convert them into a rule-based format and convert that into a passive structure. RoEs will kickback and the stock could do well; but filter eliminates them.

Active funds will capture a lot of turning points and a passive fund may not capture it. So, that could be a drawback. But at the same time, it may not make mistakes which active funds can make in trying to have human judgement. The benefit of human judgement is you can capture some turning points very well and at the same time it can go wrong. So, the fundamental part of passive fund is always about trying to eliminate human bias or significantly reduce human bias. Smart beta funds combine the benefits of passive and active funds.

Have you done some studies to figure out if this works?

Kalpen Parekh: The simplest, most original form of beta Nifty is the equal weight strategy. In India, Nifty in its current form, is a free-float market cap-based weight formula. So, the largest house gets biggest weight. So, 8-9 percent weight is for top stocks and the stock number 45-50 will have very strong weights. The elementary form of smart beta is rather than giving these types of weights to different companies, let me weigh them equally and let every company get an equal weight of two which means top 10 companies will also get 2 percent and bottom 41 to 50 stocks will also get 2 percent. So, lot of stocks which are entering Nifty or are high growth companies or companies which are likely to be value creator overtime but are getting very low weight in Nifty will get some respectable weight of 2 percent. We have evidence since 1999, which is 18 years of data. It shows that around 11 out of 18, the equal weight strategy has outperformed the market cap weight strategy. Two out of 18 years have given equal numbers. So, effectively 13 out of 18 is either same or better. Five out of 18 years, the market cap weight strategy does well which was the case last year where the top seven stocks yielded 18 percent of the return. Last year, the traditional Nifty would have done significantly better of roughly 8 percent alpha over equal weight. Over long periods of time, equal weight have generated around 2.8 percent CAGR alpha over last 18 years.

Is it better compared to the Nifty 50 returns or an actively manage large-cap fund returns?

Kalpen Parekh: In its first step, it is 2.8 percent better than Nifty in itself which means over Nifty it has generated an alpha of 2.8 percent. When you look at large-cap funds, what is the size of alpha that large-cap funds can compare over the next 10 years? If large-cap funds can do 1.5-2 percent of alpha, then it is a commendable job. History says that a pure Nifty equal weight has delivered that type of alpha. So, in a way it can be a replacement to pure large-cap strategy. Comparisons in India are not fair with large-cap funds because even today. A large-cap fund can buy 20 percent in mid-cap stocks even after the new SEBI classification. Prior to that, for the last 20 years, large-cap funds would actually buy 35 percent in small and mid caps. Lot of returns in the last 20 years may not be truly comparable to Nifty but now incrementally both will be compared like to like.

Why is it that a smart beta fund with equal weight will beat an actively manage large cap fund?

Anil Ghelani: One important thing is to eliminate human bias. No doubt actively manage funds will have capability and overweight of particular stock. On the other hand, what should that weight be or how overweight should the proportion be taken is a subjective element which is working fine for a certain time period and it can go wrong as well. Here, it is eliminating that and saying that a particular stock is coming to benchmark and let’s say it is 0.5 percent. I am by default making it 2 percent which becomes largely overweight. So, now let it perform in that context. Having said, another aspect is that it is also true in the large-cap space. Let’s say top 100 companies of market capitalisation–If you look at research coverage and information which is available of any company, the management decisions, so in that sense the access to information, research coverage has increased over a couple of decades. Within that pool, it is becoming more difficult to outperform the benchmark. At any point, I am not saying that out-performance or beating the benchmark is not possible. But it is becoming more difficult as compared to the past.

Kalpen Parekh: A good fund manager will have right wherewithal to generate alpha or out-performance, whether to Nifty or an equal weight, because then it is about how good the driver is. In a large-cap universe, our sense is being a little bit away from consensus or contrarian or having a stick of value investing, being different from rest of the market, could be a source of alpha. If 35 percent weight is in financials, so fund manager may say that if he too keeps 35 percent weight, he will still get more or less similar outcome as Nifty. So, to do different than Nifty my portfolio has to be different than Nifty. When I run a portfolio different than Nifty then there could be periods of time where this portfolios could underperform. Many times, investors are not patient enough with that patch of under-performance. So, fund manager who has that discipline, behavior to say that they could live with few quarters of under-performance because their medium to long term hypothesis is fine will still have reasonable chance of out-performance. That will incredibly be getting limited to few.

Are cost different in smart beta fund vis-à-vis some other funds?

Anil Ghelani: First three points are most important which are reduction of risk, increased potential for returns and better diversification. These are the core aspects. Cost aspect is there. But in Indian context, there are multiple other factors playing in the context.

Who should use smart beta funds? You believe that if the goal is to outperform the passive benchmark and the goal is to diversify heavy allocation to mega cap stocks.

Kalpen Parekh: I won’t necessarily say that make heavy allocation to mega cap stocks. These funds’ objective is to choose the right investment principles. What is a good investment hypothesis for long periods of time? Buy good companies at reasonably right prices—sometimes they are available and sometimes not. Once you have been able to do this, generally do nothing. Don’t disturb that compounding. Do all three of these. The fourth important dimension is reduced human biases. I won’t say eliminate as it is impossible. Human beings are doing the first three then the fourth dimension is also likely to come in. Our own personalities, bias, temperament and noise of market will come in. There is a school of thought which is globally more developed, and it is just starting in India which says that the first three things can be done with significant reduction in the fourth through rule-based products. Whether we call it smart beta, passive, rule-based but fundamentally you are just doing these four things. You are trying to do what good fund managers are doing and trying to curb the biases. The fund manager is trying to generate long term returns by playing a test match but if the umpire is a T20 umpire and the run rate is of T20, then it is a challenge. There is merit in having a part of your portfolio in a rule-based product when the rules are fundamentally designed. There are two types of quant. One is technical quant and I don’t have expertise to comment on it whether it works or not. If rules have fundamental principles of picking up good prices, good companies, eliminating weak companies, and companies with red flags, high beta or more volatile stocks. If rules are defined with right principles and then the model sticks to it and does not keep changing and remains consistent, then it is a very good ingredient for long-term value creation.

Do you think, in India, smart beta funds adoption will go up?

Anil Ghelani: Most certainly. Within the overall context of having asset allocation in an individual’s portfolio, passive investments will play an important role. It will increase overtime as a complementary strategy. It will not be just be plain vanilla passive but smart beta products. Look at these three benefits. Better returns profile, lower risk profile and wider diversification as compared to normal other products. So, it is a clear-cut thing from the growth perspective.

If we were to make an allocation of 25 percent passive and 75 percent active, if that is ideal, would smart beta be on side of weightage of 25 percent passive or 75 percent active?

Kalpen Parekh: I would put it in 25 percent passive pocket. We are coming from a two-decade period of active fund which created value. So, we still feel that value will continue to prevail but overtime if that fundamental hypothesis changes then numbers could start changing dramatically. All provident fund money from last one year has straightaway come in passive. And passive has done active. So, they have started off with big bang of being in passive funds.