Factor and Smart Beta Funds — Passive in Method, Active in Intent

A factor is a measurable characteristic shared by a group of companies, used to decide what the index holds and in what weight.

The commonly used ones include quality measures such as consistent profitability and low debt, low volatility, momentum meaning recent price strength, value meaning a low price relative to fundamentals, and size. Some indices combine two or more.

The word beta in the name simply refers to market exposure, so smart beta means taking that exposure in a deliberately different way. It is a marketing term rather than a technical one, and the schemes it covers vary widely, which is why reading the specific rule matters more than the label.

A plain market index weights companies by their size, which is itself a rule, just a familiar one. A factor index replaces that with a different rule. Our page on index funds covers the plain version and the benchmark covers why the choice of index matters so much.

Because it borrows from both sides and gives up something from each.

From passive it takes the mechanical application. Nobody decides anything month to month, the rule is published, and the cost is lower than a manager-run scheme because there is no research team to pay for.

From active it takes the intent. The whole point is to hold something other than the market, in the expectation that this particular characteristic is rewarded over time. That is an attempt to do better, which is the definition of active regardless of how it is implemented, as our page on active versus passive funds sets out.

What it gives up is discretion. A manager can decide a rule has stopped working. An index cannot, and will keep applying it through a period where it does not help.

Two of these rules behave in ways that surprise people, and both are worth knowing before holding them.

Momentum holds what has recently risen and drops what has recently fallen. It tends to do well in trending conditions and badly at turning points, when it is holding exactly the companies about to reverse. The rebalancing frequency matters here more than in other factors.

Low volatility holds companies whose prices have moved less. It typically falls less in a poor market and also participates less in a strong one, which frustrates investors who bought it after a fall and then watched a recovery from behind.

Quality and value are steadier in character but come with their own long dry spells, because a characteristic that is out of fashion can stay out of fashion for years at a time. The investor who understands that in advance sits through it. The one who bought after a strong run for that factor usually does not.

Neither behaviour is a fault. Both are the rule doing what it says, and our page on value and contra funds makes the same point about a style that can lag for years by design.

Three things, and they are all published.

The rule itself. What exactly does the index select on, and how is that measured? A vague description is a reason to read further rather than to assume.

How often it rebalances. A rule applied twice a year and the same rule applied quarterly produce different portfolios and different internal costs.

What it actually ends up holding. Some factor indices concentrate heavily in a few sectors as a side effect of the rule, which our page on portfolio overlap shows how to check against your other holdings.

Worth stating, because these schemes are marketed with a great deal of confidence.

Any factor that becomes widely known and widely bought may work less well than it once did, simply because more money is pursuing it. Evidence for these characteristics is largely drawn from long historical periods, and the Indian versions are relatively recent, so the record available to you is short.

There is also a behavioural trap specific to this category. People tend to buy the factor that has done well recently, which means arriving after the good stretch and leaving during the poor one. Doing that with a rule is no better than doing it with a manager, and our page on how returns are calculated covers why a chosen window flatters so easily.

As part of an equity allocation for somebody who understands the rule and will hold it through a period where it is unrewarded, which is the same condition our page on asset allocation applies to everything else.

Where we would question it is as a first equity holding, or as a substitute for a broad diversified scheme. A rule out of favour for four years is an ordinary event, and a new investor meeting that in their first stretch is likely to conclude that equity does not suit them.

We are distributors rather than investment advisers, we recommend no schemes, and we take no view on which factor will be rewarded. If you want to work out whether this belongs in your plan at all, get in touch, and how to choose a mutual fund sets out the order of decisions.