Include smart-beta funds to generate alpha in your portfolio

In recent times, smart-beta funds, also called factor-based funds, have begun to gain popularity. Some of the factors on which these funds are based are value, quality, low volatility, alpha plus low volatility, momentum, etc.

- Sudipta Mitu

Most investors would be familiar with index funds and exchange-traded funds (ETFs) based on popular indices such as the Nifty and the Sensex. These are market cap-based indexes. In the Nifty, for instance, the top 50 stocks having the highest free float market capitalisation are selected. Larger stocks having higher market cap get a bigger weight within the index.

Factor-based indexes are built differently. Suppose that a quality index has to be built. One parameter for quality is return on equity (RoE), another is low debt-to-equity ratio. An index constructor will apply these parameters (and several others) to all the stocks in the market and select those that have the highest consolidated score based on these parameters. Different combinations of parameters are applied, and back testing is done. A factorbased index is launched based on the combination of factors that yields the best results in back testing.

With market cap-based index funds and ETFs, an investor can only get market-equivalent returns. Factor-based funds or smart-beta funds try to beat these market cap based indexes. In other words, their goal is to provide alpha to the investor.