Mutual funds: Know what makes smart-beta index funds smart

Empirical research shows that index investing tends to outperform active funds over long time-frames

By Malvika Saraf and Parthajit Kayal

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Index investing is a passive investment strategy that attempts to generate returns similar to a broad market index, such as Sensex and Nifty. Investors use this strategy to replicate the performance of a specific index—generally an equity—by purchasing the component stocks of the index or investing in an index mutual fund or exchange traded fund that itself closely tracks the underlying index.

Most fund managers of active funds fail to beat the index over the long term. Further, active funds are expensive due to high fees. Moreover, for a retail investor, the process of active fund selection for investment is a tedious job similar to a stock selection. It is an art that requires a process and thus most investors with limited knowledge must stick to an index fund instead of trying to find active funds that might beat the index.

Advantages of index investing

Empirical research shows that index investing tends to outperform active funds over long time-frames. Index investing approach eliminates many of the cognitive biases and human errors that arise in a stock-picking strategy. It is an effective technique to manage risk and acquire consistent returns. Since index investing takes a passive approach, index funds usually have lower management fees and expense ratios. The simplicity of tracking the market without a portfolio manager’s direct involvement, allows providers to maintain modest fees.

Index funds also tend to be more tax-efficient than active funds because they make less frequent trades. More importantly, index investing is an efficacious method of diversifying against risks. An index fund consists of a wide basket of securities instead of a few investments. This serves to mitigate unsystematic risk-related to a specific company or industry.

Limitations of index investing

Despite gaining immense popularity in recent years, there are a few limitations to index investing. Many index funds are formed on a market capitalisation basis, meaning the top holdings have an outsized weight on broad market movements. So, for example, if Reliance or TCS experience a weak quarter it would have a noticeable impact on the entire index. Further, this approach neglects a subset of the investment universe focused on market factors such as value, momentum, and quality. These factors now constitute a corner of investing called smart-beta, which attempts to deliver better risk-adjusted returns than a market-cap-weighted index.

Smart-beta funds offer the same benefits of a passive strategy, with the additional upside of active management, otherwise known as alpha. Index investing does not provide any downside protection. Also, since it is a broad market index, investors do not have the liberty to choose the index fund’s composition.

Performance of index funds

Previously index investing was based only on broad market indices such as Nifty50, Sensex, etc. Stock exchanges have developed different types of indices for passive investment strategy across sectors, strategy, theme, fixed income, etc. The National Stock Exchange of India has developed many such indices.

The Nifty 50 or Sensex have generated a CAGR of around 12-13% in the last 10-12 years. However, for investors’ reference, we find Nifty 200 Momentum 30 and Nifty Alpha 50 index have generated much higher than Nifty 50. Further, returns of Nifty Alpha Quality Low Vol 30, Nifty Midcap150 Quality 30, Nifty 100 Alpha 30 indices have also generated relatively higher returns than Nifty 50 (see graphic). Investors can study these indices in detail separately to have a better idea.

Passive investors looking for better returns than broad market indices may go with such smart-beta index funds that could potentially offer better returns with much lower fees than active funds. Many mutual fund houses have started to offer these types of index funds for retail investors.

Saraf is a recent graduate, Madras School of Economics and Kayal is assistant professor, Madras School of Economics