Smart Beta etf Exploring the Factors that Drive Return

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Marketopedia / Importance of Personal Finance / Smart Beta etf Exploring the Factors that Drive Return

In chapters 6 & 7, we touched upon the essential components of mutual funds and how they function. We then delved into a particular kind of index fund in chapter 16. As we had expected to discuss smart-beta funds and ETFs – a relatively novel inclusion to India’s financial sphere – our plan was put on hold. This current chapter intends to provide you with an adequate understanding of these funds.

The term ‘smart-beta’ draws strong reactions from investment professionals. It may seem fancy, but it’s essentially another name for factor investing and any other weighting methodology that differs from market-capitalization indexing. As mentioned previously in the chapter on index funds, an index fund is a market-cap weighted benchmark such as the Nifty 50 or Nifty 500.

It is worth noting that market-cap-weighted indices use the market cap to determine their weightings, meaning the higher a company’s capitalisation, the more prominent its presence in the index. A popular example of such an index is the Nifty 50.

Fundamentally weighted exchange traded funds (ETFs) are also available, such as index funds which assign a weighting to stocks based on criteria such as income, dividends, and profitability.

– What is a factor; you might be wondering?

A factor is a foundational driver of the returns of a stock. Expressed differently, in factor investing, you seek out stocks which feature a specific characteristic that can influence their returns. Keep this meaning in mind, and we’ll circle back to it soon. Still, before we do that, it’s also worth getting acquainted with some background information for context.

Factor investing has been the result of extended academic study, beginning with the Capital asset pricing model (CAPM) and efficient markets hypothesis (EMH). CAPM suggested that a single factor, beta or market risk, dictated returns – a theory which was not widely accepted. Nevertheless, this idea gained traction when Eugene Fama and Kenneth French published their influential research article – The Cross-Section of Expected Stock Returns.

Fama and French extended their model by introducing two additional factors; Value and size and the market factor. This signified that there were other determinants to stock returns beside only the market risk. This development was termed as the Fama French 3-factor model. Then, in 2014, it became a 5-factor model with the addition of profitability and investment factors.

Apart from the widely-known Fama French factors, Momentum and Low Volatility have also been discovered. To understand these factors better, Robeco provides a helpful overview of the most generally used ones.

 

Investors seek out stocks that demonstrate these characteristics, forming factor portfolios.

In India, not much information exists about factor performance. Most smart beta indices are fairly fresh. Nevertheless, below is an overview of how momentum, quality, and low volatility have done in comparison to the Nifty 50 and 500 indices.

Strong performance has been observed across the board with low volatility and minimal decline. Additionally, Nifty Alpha, a metric for momentum of the index, has demonstrated solid gains but with more risk associated.

Here are the annual returns for a more granular look.

But, it’s also important to understand why these factor premiums exist in the first place. There are broadly 3 reasons market practitioners and academics propose:

Risk-based: It is widely accepted that factor premiums exist due to the increased risks associated with them. For instance, academic studies have revealed that value stocks, i.e. those with a lower price tag, tend to outperform their expensive competitors over time. However, these cheaper companies may pose a higher risk of defaulting or ending up in financial difficulty during an economic downturn.

Behavioural-based: This camp suggests that factor premiums are due to behavioural biases among investors. For instance, they believe the value premium exists because people tend to invest in growth stocks deemed glamorous, while overlooking cheap value stocks. Similarly, they think the momentum effect originates from investor under-reaction and then overreaction, which leads to a loop that elevates prices.

Structural issues: This camp states that certain premiums exist because of structural factors such as lack of liquidity, prohibitive transaction costs, and the impossibility of borrowing.

It’s unlikely there is any one answer, as humans and markets are both complex entities. It would be unwise to make any other assumptions.

At this point, you may have dismissed everything I wrote after the charts due to their impressive returns. However, it is important to note that there are no shortcuts in investing – except for diversification.

 – Smart-beta funds in India

Smart beta or factor funds have been available in India for around 4-5 years, with the first ETFs launched during this period. While some quant funds from Reliance, Tata and DSP do exist, their methodologies are not as transparent as those of smart beta ETFs.

It should be noted that the performance of real-life trades will, of course, vary from these index returns. Given that markets have become much more efficient since 2005, when these indices began, costs, slippage, and microstructure changes may all contribute to the discrepancy.

The launch of a few smart-beta funds in recent years provides limited information on their actual trading performance. However, assessing the quality, value, and low volatility ETFs compared to the Niftybees gives us an insight into how they are performing.

 

This data is from 2019, and it’s not a lot to conclude, but it is evident that not all factors perform all the time.

Factor or smart beta ETFs have been available for trading in the US for a longer period and here’s how some of the more celebrated smart ETFs have done against the S&P 500. While we must consider the possibility of starting point bias since this was the point from which all primary factor ETFs had continuous trading data, it doesn’t alter our verdict.

It’s apparent from the data in the Indian context that factors have a cyclical nature, and may not always outperform lower-cost broad market index funds. The top factors are continually changing over time.

                                                               

 ICICI Quant Fund presentation

Value stocks have lagged behind growth stocks as represented by the S&P 500 for more than 10 years. To illustrate, US data is easier to find, whereas the Indian markets are distinct.

Visualise what it would be like if you invested all of your money in value, though not many people do. Yet, each factor can have various interpretations and strategies when implemented. For instance, according to Fama and French’s paper, value is calculated as price to book; however, the metrics that are used for each ETF or index can differ, such as price to sales, EBIT/TEV or forward earnings. This brings about huge variations in returns amongst identical or related funds.

– Do smart-beta funds work?

Sceptics generally contend that factors are simply “backtests” and there is data-mining involved which does not always yield successful results. Conversely, some people posit that while they may have been good indicators at one point in time, they no longer work as expected.

 

On the other side you’ll find staunch supporters of factors. Asset management companies that implement factor strategies handle immense sums of money, with Dimensional Fund Advisors (DFA) being one of the most eminent. Founded by David Booth, they managed more than half a trillion dollars in assets. Booth was a student of Eugene Fama at the University of Chicago’s business school and Fama currently sits on DFA’s board.

I am confident that the premiums of factors can change over time and therefore require long-term commitment for a successful harvest. It should be noted, however, that there is still a great amount of effort required to realise the rewards.

Investors must be aware that the markets are continually evolving. In the 1990s, when factor investing was first introduced, there were still many inefficiencies and retail investors composed a sizable portion of the markets.

With modern technology, individuals have immediate access to data at the touch of a button through their smartphones. There are countless CFA holders and hedge funds managing extraordinary amounts of money that are always on the lookout for new investment opportunities. India has also seen a significant surge in mutual funds, PMS’, AIFs, HFT traders and institutional investors playing an influential role in their markets.

It is unlikely that the factors have been arbitraged away; investors should not just consider past returns of indices and backtests and expect the same results. The chances are the premiums may not be as considerable as they appear.

Data and computing power have allowed for the emergence of hundreds of new factors identified through data mining. If you examine their backtests, they appear to be highly successful; however, they can often be unreliable. This has been coined the “factor zoo” by many practitioners and academics.

 – Should you invest in smart-beta funds?

I do not recommend investing your entire equity portfolio in smart-beta funds. Furthermore, they should not be seen as alternatives to index funds or good quality active funds with a dependable performance.

As we saw in the preceding chapter on index funds, a majority of active funds tend to underperform their benchmarks. Therefore, I believe that smart-beta funds are an appropriate alternative for poorly managed discretionary active funds. Most of your equity allocation should be devoted to reliable diversified active equity funds or index funds. This can then be augmented by investing in smart-beta funds, with the possibility of enhanced returns.

Do bear in mind that factors can experience a period of under-performance compared to a simple index fund. The premiums associated with them are also liable to fluctuate as more funds are launched in India and money shifts towards them. Be mindful that market forces come at a cost; every decision you take as an investor has a trade-off. To access the bigger returns from something like an index fund, you have to be ready to face any accruing pain.

Diversifying among factors is a viable solution. While there are multi-factor funds available in India, they may not be as transparent as index-based smart beta ETFs. ICICI alpha low volatility ETF, recently launched, combines two momentum and low volatility factors. Other investments in this area include DSP Quant Fund and Tata Quant Fund.

We are seeing AMCs gradually introduce these funds, and hopefully, a wider range will be available in the coming years.

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