Smart-Beta Value Funds Surge: PSU Impact, Not True Value

Indian smart-beta index funds, specifically those focused on value, have recently experienced a significant turnaround in performance. This reversal over the last two years was largely fueled by the robust showing of Public Sector Undertakings (PSUs) heavily represented within these indices.

Unlike traditional market-capitalization-weighted indices, smart-beta funds employ rule-based factors such as value, momentum, quality, or low volatility for stock selection and weighting. Historically, several value-factor smart-beta indices in India had lagged the broader market.

PSU Concentration Drives ‘Value’ Gains

The recent sharp reversal in these value-factor funds, observed over the last two years, directly correlates with the strong performance of PSUs. This indicates that the gains stemmed from sector-specific strength rather than a fundamental validation of the ‘value’ investing style itself.

• Value-factor smart-beta indices had previously underperformed the broader market.
• Their recent turnaround is primarily attributed to strong Public Sector Undertaking performance.
• The concentration of PSUs within these indices was a key driver of returns.

Strategic Allocation for Smart-Beta Funds

Investors considering these smart-beta funds must understand the underlying holdings and the actual drivers of returns, moving beyond just the factor label. Value Research suggests a conservative approach to allocation.

• Start with 5-10 percent of an equity portfolio for conservative investors.
• Do not exceed 20 percent of the equity portfolio, even for aggressive investors.
• Avoid chasing factors that have recently performed well, as factor performance tends to rotate unpredictably.

Aligning the chosen factor with an investor’s temperament is crucial for long-term success. Different factors suit different risk appetites and investment horizons.

• Aggressive investors might consider momentum-based indices.
• Moderate-risk investors could prefer low-volatility or quality indices.

Dhirendra Kumar of Value Research expressed caution in 2021 regarding these funds due to their limited live track records. The recent PSU-driven ‘value’ reversal reinforces the ongoing challenge of distinguishing genuine factor premia from sector-specific coincidences.

Understanding these dynamics is vital for investors aiming to integrate smart-beta strategies into their portfolios effectively. The true efficacy of a factor must be evaluated beyond short-term, sector-specific rallies.