Exit a fund only if risk appetite changes or tracking error widens

Experts say investors should not exit smart-beta funds due to short-term underperformance as factor strategies are cyclical and tend to recover

Several smart-beta funds have underperformed frontline indices like the Nifty 50 over the past year. Investors must avoid knee-jerk reactions to short-term underperformance. 

Cyclical underperformance 

Momentum funds faced a sharper reversal over the past year. “Exposure to cyclicals and midcaps may have amplified their losses in a volatile market,” says Chintan Haria, principal - investment strategy, ICICI Prudential Mutual Fund. 

Experts say this underperformance is cyclical. “Momentum typically faces reversals after exte­nded rallies,” says Haria.No single factor leads every year. “Momentum leads in bull markets but is vulnerable during reversals. Quality and low volatility are defensive factors that show lower drawdowns during downturns,” says Vikash Wadekar, head - passive business, Axis Asset Management Company (AMC). 

Factor-specific risks 

Smart-beta funds expose investors to factor-specific risks besides market risk. “Momentum and alpha can underperform sharply during market reversals. Low-volatility and quality may underperform in strong bull phases,” says Haria.  A factor that has historically outperformed can underperform for an extended period in the future. 

Stay invested 

Investors must look beyond short-term returns. “Three- and five-year compounded annual growth rates remain healthy across most factors,” says Wadekar. 

Remember that leadership rotates across factors. “Momentum underperformed in 2022 but outperformed in 2023 and 2024,” says Wadekar. Smart-beta strategies work over multi-year cycles. “Stay invested if the strategies to which you have exposure align with your risk tolerance,” says Haria. Exiting after a weak phase locks in losses. You could also miss out on the ensuing recovery. 

Ensure that the funds you hold have a low tracking error, reasonable turnover, and stable methodology. 

Diversify exposure 

Avoid heavy exposure to a single factor. “Using a combination of factor funds or a multi-factor approach yields more stable returns over time, mitigates risks and enhances portfolio resilience,” says Wadekar. Modest rebalancing semi-annually can help. “Reduce exposure to volatile factors like momentum and increase allocation to defensive ones like low volatility and quality to stabilise returns,” says Haria. 

Avoid exiting 

Exits should be the exception rat­her than the norm. “Exit if your risk appetite and asset allocation have changed,” says Pratik Oswal, chief of passive business, Motilal Oswal AMC. “Exit if tracking error widens meaningfully, or if there are flaws or inconsistencies in the methodology for index construction,” says Arihant Bardia, chief investment officer and founder, Valtrust. 

Enter cautiously 

First-time investors should begin with plain-vanilla index funds or established active funds. “Smart-beta indices tend to have higher volatility and deeper drawdowns, making them unsuitable for conservative or new investors,” says Bardia. Oswal suggests investors choose factor funds that complement their existing portfolio. 

New investors should review the index’s track record, espec­ially the duration of past drawdowns. If investing via an ETF, pay attention to its size and liquidity. “Thinly-traded ETFs and those with high tracking error can increase risks,” says Bardia. 

Investors may begin with a 5–10 per cent allocation to smart-beta strategies. “This can rise to 10–15 per cent for investors with higher risk tolerance and conviction. Have a three- to five-year horizon,” says Prashasta Seth, chief executive officer, Prudent Investment Managers. 

Seth adds that multi-factor strategies can justify slightly higher allocations with a minimum horizon of three years. 

 

The writer is a Mumbai-based independent journalist