Smart beta investing will become central to India’s investment management industry, says OpenQ

Smart beta investing may not be mainstream in India yet, but experts at OpenQ believe the country is poised to follow the route that the United States took after the 2008 global financial crisis, but at a much faster pace.

Smart beta investing will become central to India’s investment management industry, says OpenQ

Thursday April 06, 2023,

7 min Read

Reports state that in US Smart beta Exchange-Traded Funds (ETFs) gathered a record $94 billion of net inflows in 2022, indicating that many investors want something other than only replicating the S&P 500 Index.

These may be the initial years for smart beta investing in India, but experts at OpenQ highlight that India is poised to follow the route that the United States took after the 2008 global financial crisis, but at a much faster pace. 

Smart beta is a rule-based investing strategy, which combines principles of active management with a passive approach. This strategy uses well-researched factors to select and weigh stocks along with creating a systematic portfolio.

Smart beta investing aims to obtain alpha returns, lower risk, or increase risk diversification at a cost lower than traditional active management and marginally higher than straight index investing.

When the smart beta phenomenon started in the US, there were only academic papers and discussions around it. But the scenario changed soon after the 2008 meltdown.

The regulatory changes in India in 2017-2018 created the need for an investment philosophy that could generate better returns at a lower cost of production, academically backed with global validation, and could become the mainstream investment philosophy. Smart beta investment was the only solution that ticked all the boxes. 

What is a smart beta investment strategy?

Smart beta investment – an indexing strategy – could become an important alternative to mutual fund investment offerings.

Factors like low volatility, quality, momentum, and equal weighting, which have shown past results of potentially higher returns, are considered while selecting these stocks. The momentum of new launches in the category has led many traditional players to embrace the shift as well.

Investors across the globe are increasingly using smart beta-based passive investment strategies as building blocks in their asset allocation models in their quest to outperform the market, either on an absolute basis or on a risk-adjusted basis, or both. These strategies aim to provide a systematic risk-adjusted return premium by achieving a specified high level of targeted factors. They also aim to produce risk and return profiles, portfolio diversification and return enhancements relative to traditional market capitalisation benchmarks. 

A number of smart beta-based PMS and AIF schemes are also gathering investor attention. The rise of platforms like SmallCase & WealthDesk has led to the launch of a lot of these products in smaller ticket sizes for retail investors. Currently, there are over 75 such portfolios, from over 27 investment houses and RIAs.

Studies have revealed that factor-based investment performs well in the long-time horizon, even during market downturns and recessionary phases. 

Why should investors choose smart beta funds?

The debate between active and passive has been going on for quite some time now, owing to two reasons: cost sensitivity and the inability of more than half of active funds to outperform the benchmark.

As per the SPIVA India Scorecard, over 80% of large-cap funds and 50% of mid and small-cap funds underperformed their benchmarks.

ICI research shows that more than $2 trillion of assets flowed from active to passive funds over the last 10 years. Based on these studies, experts said that factor investing seems to be well-positioned to harness the best of both active and passive investing worlds. 

Since factor construction is data-driven and non-discretionary, there is no need of setting up a huge infrastructure that is associated with the active world – bringing down the overall production cost and offering the benefit of active exposure at a fraction of the cost.

This is the reason why factor investing has been steadily rising post 2008. Studies show that smart beta funds (alternatively called factor funds) reached an Assets Under Management (AUM) of $1 trillion by March 2021. 

Factor investing: The Indian scenario

Factor investing is a rule-based investment strategy in which investments are chosen based on certain factors, either macroeconomic factors like inflation, economic growth and liquidity, or style factors like volatility, value and momentum. These factors can help investors generate higher returns, increase diversification, and manage overall risks of the investment portfolio.

As opposed to traditional investing, factor investing is better in terms of transparency, performance, diversification, and zero human bias among other reasons.

Despite the start, India is not close to the levels of the west when it comes to factor investing. The regulatory landscape could be one of the reasons. However, this changed when SEBI released a circular on the Categorisation and Rationalisation of Mutual Fund Schemes in October 2017, with explicit definitions of large-cap, mid-cap, and small-cap funds.

As a result of this circular, the universe for stock selection within schemes became common across all AMCs, which eventually led to the convergence of scheme returns within a particular band. However, convergence became more pronounced within large-cap funds, as compared to mid and small-cap. Differentiation within the same scheme across varied AMCs became difficult, too.  

In January 2018, SEBI came out with another circular, requiring fund houses to benchmark their schemes to the Total Return Index as against what they were doing till now - benchmarking their indices to the Price Return variant. The difference between Total Return and Price Return is the dividend yield, which means that fund houses would have to generate extra returns equal to the dividend yield at least to break even with the benchmark.  

A study done by Morning Star India in September 2017 revealed that the number of funds beating their benchmark declined from 85% to 58% when compared with Total Return Index vs Price Return Index.

Lack of differentiation, benchmarking to total returns (higher breakeven), and capping of expense ratio led to a structural change in the smart beta investing landscape, which has seen significant growth in the last four years.  

Experts found that from the demand side, there was a strong momentum of inflows into this space. Be it via index funds, which are launched on top of NSE and BSE Smart Beta Indices or via actively managed smart beta funds, the combined AUM in such funds/ETFs combined rose to over Rs 23,000 crore. Of this, more than Rs 13,000 crore came in the past year alone.

However, strong demand kept the mutual fund industry busy on the supply side, with an increasing number of launches, especially in the index fund space. The year 2022 witnessed the highest number of fund launches. Currently, an investor can take exposure to smart beta strategies either through ETFs /index funds/fund of Funds launched on top of Nifty Smart Beta indices or through some actively managed smart beta funds, a subset of quant funds. 

The road ahead for India’s investment industry

Value and quality have been the go-to factors for most fund managers in the past, which makes NIFTY’s Momentum Index, launched in August 2020, the first of its kind in India.

Today ABSL, HDFC, ICICI Prudential, IDFC, MOSL and UTI have launched ETFs on the NIFTY 200 Momentum 30 Index. AMCs like Motilal Oswal and ICICI Prudential have also launched a complete suite of smart beta ETFs. 

Some ETFs centred on value and quality are Kotak and ICICI Prudential, tracking NSE NV 20 index. Edelweiss also has an ETF tracking the NSE Quality 30 Index while DSP has mid-cap quality ETFs on Nifty Midcap 150 Quality 30 Index, among others. Some AMCs have also launched FOF (Fund Of Funds) on the same underlying index on which ETF has already been launched. ICICI Prudential has both ETF as well as FOF on the Nifty 100 Low Volatility 30 Index and the Nifty Alpha Low Volatility 30 Index.  

With the NFO launches in passive funds, one would generally expect market share to be skewed towards passive smart beta schemes. But the AUMs reveal a different scenario. With half the number of schemes compared to passive, active funds control more than twice the AUM of passive funds. 

Given the kind of growth smart beta investing has seen in the US and the kind of regulatory changes seen in India, experts believe that smart beta investing would become central to India's investment management industry in the near future.

So far, the industry has mostly focused on factors like value or quality. But going forward, experts expect strategies around price-based factors like momentum will gain ground.