Smart Beta Funds

A smart beta fund blends elements of active and passive investing strategies. It starts with a passive approach by tracking a market-cap-based index, such as the Nifty 200 or Nifty 100. However, instead of simply mirroring the entire index, the fund applies specific investment rules known as 'factors'.
What are Smart Beta Funds?
4 mins
07-October-2024

You can invest money in two ways: active and passive. Active investing refers to generating above-market average returns (usually called alpha) by paying fees to fund managers. Conversely, passive investing involves tracking indices like Sensex or Nifty to generate returns at a lower cost.

Given the benefits of both investing types, investors always feel the need for a blended product that offers the advantages of both active and passive strategies. This led to the development of “smart-beta funds”, which offer a hybrid investment approach by combining active and passive investing elements.

The primary goal of these funds is to deliver better returns than traditional passive funds at lower costs than active management. Unlike passive funds that track market indices like the Sensex or Nifty, smart-beta funds select stocks based on specific factors such as momentum, value, volatility, and quality. This systematic stock selection enhances returns while maintaining lower fees, just like passive investing.

Furthermore, it must be noted that the returns of smart-beta funds are influenced by how well the selected factors perform in the market. Also, the approach of smart-beta funds is transparent and follows a set of rules. This means their criteria for selecting stocks are clear and consistent, not based on the fund manager's subjective choices.

Let’s explore the meaning of smart-beta funds, understand how they work, and learn how to invest in them.

What are smart beta funds?

Smart-beta funds employ alternative weighting methodologies to traditional market capitalisation-based approaches, aiming to outperform the broader market. The term "smart" signifies the fund's use of factor investing strategies and academic research to select and allocate weights to securities within an index.

Common smart-beta fund strategies include:

  • Equal weighting: Each security in the index receives an equal allocation, mitigating the concentration risk associated with market capitalisation-weighted indices.
  • Fundamental weighting: Securities are weighted based on fundamental factors like earnings, dividends, or sales, rather than market capitalisation.
  • Low volatility: The fund underweights volatile stocks and overweights those with lower volatility, seeking to reduce risk.
  • Quality: The focus is on high-quality companies characterised by strong balance sheets and profitability.
  • Value: The fund favours undervalued stocks, often identified by low price-to-earnings ratios or other valuation metrics.

How do smart beta funds work?

  • Smart beta funds utilise a different weighting method compared to traditional market-cap weighted funds.
  • They do not follow standard indices like NIFTY 50 or SENSEX based on market capitalization.
  • These funds belong to factor investing, where factors like value, momentum, low volatility, and size and quality influence stock selection. For instance, a value-focused approach seeks companies with share prices lower than their intrinsic value.
  • Various metrics such as PE ratio, PB ratio, and dividend yield are used to select these undervalued stocks.

Key principles of smart beta funds

Smart beta funds operate based on two fundamental principles:

  1. Systematic factor exposure
  2. Rules-based approach

Firstly, they aim for systematic factor exposure, targeting specific factors like value, quality, momentum, low volatility, and size believed to impact stock returns. For example, a smart beta Fund may focus on stocks with low price-to-earnings (P/E) ratios to leverage the value factor. Secondly, Smart beta funds adopt a rules-based approach, unlike traditional actively managed funds. This means their strategy relies on predetermined and transparent rules or algorithms instead of subjective human judgment. This structured approach enhances transparency and consistency in decision-making processes within smart beta funds.

Performance of smart beta funds

Smart beta exchange-traded funds (ETFs) are designed to optimize investment returns by blending the advantages of active and passive strategies. The Nifty100 Low Volatility 30 Index, a representative smart beta ETF, tracks the performance of low-volatility stocks within the large-cap market.

Globally, smart beta ETFs have gained prominence for their potential to generate alpha through diverse investment criteria. Their performance has been impressive, with a compound annual growth rate (CAGR) of approximately 24.1% over the past five years.

Compared to the 4,912 ETFs based on traditional market capitalisation, smart beta strategies underpin approximately 1,275 ETF products. This underscores the enduring appeal of traditional market cap ETFs, which have exhibited a 5-year CAGR of around 23.7%.

Factor-based investments, particularly those focused on low volatility, offer a compelling advantage, especially during economic downturns. Low volatility strategies demonstrate long-term resilience compared to momentum-based approaches, which excel in bull markets but may underperform during market declines. Notably, low volatility portfolios generally exhibit lower turnover, while momentum portfolios tend to have higher turnover.

Smart beta funds with multiple factors

Multi-factor Smart Beta Funds provide investors with a distinct opportunity to enhance portfolio diversification while adhering to a passive investment strategy. By incorporating multiple factors, these funds construct a basket of equities designed to outperform single-factor strategies. The following table outlines several prominent indices that employ a combination of up to four factors:

Index

Number of Factors

Weights

NIFTY Alpha Low-Volatility 30

2

50% Alpha, 50% Low Volatility

NIFTY Alpha Quality Low-Volatility 30

3

33% Alpha, 33% Quality, 33% Low Volatility

NIFTY Alpha Quality Value Low-Volatility 30

4

25% Alpha, 25% Quality, 25% Value, 25% Low Volatility

NIFTY Quality Low-Volatility 30

2

50% Quality, 50% Low Volatility


A common belief among investors is that multi-factor Smart Beta Funds consistently outperform single-factor funds. To validate this hypothesis, a comprehensive analysis of Smart Beta index performance, risk, and return is necessary.

Advantages of smart beta funds

Smart beta funds offer the benefits of diversification. They follow consistent rule-based investing and often generate higher returns at comparatively lower costs. For more clarity, let’s understand their various advantages:

Enhanced diversification

Smart beta funds often invest in a wider variety of assets compared to traditional, actively managed funds. This diversification helps spread risk, which means if one investment performs poorly, it doesn't affect the entire portfolio.

Lower costs

These funds generally have lower fees than actively managed funds. They aim to give you the benefits of active management without the high expense ratios.

Rule-based strategies

Smart beta funds follow clear and predefined rules for selecting investments. This eliminates emotional decision-making and leads to more consistent investment choices.

Specific investment goals

These funds can be tailored to meet specific investment objectives like generating income, achieving growth, or finding value. Such flexibility makes them versatile, which means it is highly likely that there is a smart beta fund designed to match your particular investment goals.

Historical outperformance

Some smart beta strategies have historically performed better than traditional market indices. Mostly, they appeal to investors who are seeking higher returns.

When does smart beta make sense?

Smart beta funds are ideal for cost-effective diversification and those who can tolerate some investment risk. They are also a preferred choice for investors with specific long-term goals. Let’s see when investing in smart beta funds makes sense:

Diversification

If you want to have a variety of investments without spending too much on fees, smart beta funds are a good choice. They offer a cost-effective way to spread your money across different assets. This reduces the impact of a single underperforming investment.

Specific goals

If you have clear investment goals, like looking for undervalued stocks (value) or earning a regular income, smart beta funds can be tailored to match these goals. Given this flexibility, there is a high chance you can find a smart beta fund that fits exactly what you are trying to achieve.

Risk tolerance

If you have a long-term investment horizon and are comfortable with the risks that come with investing, smart beta funds can be a balanced option. They combine aspects of both active and passive investing. This blended approach makes them suitable if you can handle some risks while aiming for higher returns over time.

Disadvantages of smart beta funds

As discussed above, smart beta funds offer several benefits. However, they also have a few drawbacks, such as no guarantees of success, complexity, and a short performance history. Let’s study some major disadvantages:

1. Lack of active flexibility

Smart beta funds are not fully active. They follow predefined rules and strategies, which limits their ability to quickly adapt to sudden changes in the market or take advantage of new investment opportunities.

2. No guarantees

Like any investment, smart beta funds also come with risks. The fact that a smart beta fund has done well in the past does not guarantee it will do well in the future. Investors must understand that there is a chance that some strategies used by these funds might not perform as expected and could result in losses.

3. Complexity

The rules and strategies of smart beta funds can be complicated. This complexity can sometimes make it harder for the average investor to understand them fully. Also, it causes challenges to determine whether a particular fund’s approach aligns with their personal investment objectives.

4. Limited track record

Being a novel product, some smart beta strategies haven’t been around for long and have a limited track record. This makes it harder to judge their long-term performance and reliability.

Factors affecting smart beta funds

Smart beta funds consider various factors like value, quality, momentum, low volatility, and size to construct portfolios and capture specific market attributes. These funds offer investors access to a diverse array of factors beyond traditional market capitalisation. Understanding these factors is key to unlocking the potential benefits of smart beta funds.

  • Value: Value investing is about uncovering undervalued stocks relative to their intrinsic worth. Smart beta funds focusing on the value factor typically target stocks with low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, or other value-related metrics. These metrics help identify stocks with strong potential for growth.
  • Quality: Quality-oriented smart beta funds prioritise companies with robust financials, steady earnings, and minimal debt. Emphasising profitability, effective management, and solid governance, these funds aim to construct portfolios resilient to market volatility.
  • Momentum: Momentum-driven smart beta funds capitalise on the tendency of winning stocks to sustain their upward trajectory. These funds select stocks exhibiting strong recent price performance, betting on the continuation of positive trends in the market.
  • Low volatility: Low volatility strategies focus on stocks with historically stable price movements. By minimising exposure to high-risk equities, these smart beta funds offer investors a smoother investment journey, shielding portfolios from drastic market fluctuations.
  • Size: Size-based smart beta ETFs tilt their portfolios towards smaller company stocks, known as the small-cap factor. The rationale behind this strategy lies in the belief that smaller businesses have greater growth potential and room for expansion, offering opportunities for higher returns over time.

How to invest in smart beta funds?

Primarily, investing in smart beta funds involves diversifying strategies and reinvesting for growth. If you believe smart beta funds can be a good choice for your financial goals, below are some investing tips:

 

  • To diversify and spread risk, always combine different smart beta approaches, such as value (undervalued stocks), quality (strong financials), and low volatility (stable stocks).
  • Select a benchmark (like an index) to compare the performance of your smart beta fund. This helps assess how well it is doing relative to the broader market.
  • Opt for funds with low expense ratios (ideally under 0.5%). Be aware that higher fees can reduce the advantages of smart beta investing.
  • Reinvest dividends to benefit from compounding returns over time. Prefer following a long-term investment strategy.
  • Use smart beta for your core passive investments (not the whole portfolio). To diversify further, consider blending with some actively managed funds.
  • Review your fund's holdings periodically to ensure they align with the chosen smart beta strategy.
  • If you are investing in ETFs (exchange-traded funds), be mindful of their tax implications. Moreover, compare their after-tax returns to make informed decisions.

Smart beta funds – Merits and concerns

Smart Beta Funds have emerged as a popular choice among Indian investors due to their systematic and transparent approach to investing. Unlike actively managed funds, which rely on subjective judgments and may be influenced by emotional biases, Smart Beta Funds employ rules-based strategies, enhancing predictability and reducing the potential for human error. By diversifying portfolios and mitigating risk, these funds offer a compelling alternative for investors seeking to achieve consistent returns.

A key advantage of Smart Beta Funds is their lower expense ratios compared to actively managed funds, resulting in significant cost savings for investors over time. This cost efficiency allows for greater returns, making these funds an attractive option for those seeking to maximize their investment outcomes.

However, it is essential to consider the potential limitations of Smart Beta Funds. The scarcity of historical data on factor indices in the Indian market poses challenges in assessing their performance during prolonged periods of market downturn. While the available data from the 2008 and 2020 market corrections provides some insights, investors should exercise caution and carefully evaluate the risks associated with this investment strategy.

Should you invest in smart beta funds?

Smart beta funds offer advantages over traditional market-capped index funds and actively managed funds. Notably, they are cheaper than active funds and aim to provide returns that surpass standard benchmarks.

Considering these benefits, allocating 15-25% of your investment portfolio to smart beta funds can be wise. However, it's crucial to monitor these funds regularly. That’s because markets, sectors, and companies are constantly evolving, which can affect how these funds perform. Also, some new factors may emerge that impact their strategies and outcomes.

Conclusion

Smart beta funds offer a systematic approach to investing, blending elements of passive and active strategies. While they present potential benefits, investors should exercise due diligence and consider their overall financial plan and objectives when incorporating smart beta funds into their portfolio. Understanding the principles and factors behind smart beta funds is essential for navigating the complexities of the investing landscape.

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Frequently asked questions

Is the expense ratio lower in smart beta funds?

The expense ratio in smart beta funds can vary but is generally lower compared to actively managed funds, offering cost-efficient investment options for investors seeking factor-based strategies.

Are smart beta funds subject to any tracking errors?

Smart beta funds may experience tracking errors due to factors like imperfect replication of indices, trading costs, and rebalancing strategies, which can affect the fund's performance relative to its benchmark index.

Are smart beta funds considered to be liquid funds?

Smart beta funds are not liquid funds. Smart beta funds vary in liquidity depending on factors like asset size and trading volume, but they generally offer liquidity similar to traditional index funds, allowing investors to buy and sell shares with ease.

Who should invest in smart beta funds?

Investors seeking a blend of active and passive investment strategies, looking to diversify their portfolios, and capitalize on specific market factors may find smart beta funds suitable for their investment objectives.

How is a smart-beta fund a mix of active and passive funds?

A smart beta fund blends elements of active and passive investing strategies. It starts with a passive approach by tracking a market-cap-based index, such as the Nifty 200 or Nifty 100. However, instead of simply mirroring the entire index, the fund applies specific investment rules known as 'factors'. These factors, like momentum or low volatility, are similar to the strategies used in active management but are predefined and systematic.

For example, in the Nifty 200 Momentum 30 fund, the fund selects 30 stocks from the Nifty 200 index that have shown the strongest recent performance momentum. Similarly, the Nifty 100 Low Volatility 30 fund picks the 30 least volatile stocks from the Nifty 100 index.

What is the difference between smart alpha and smart beta?

Smart beta strategies are systematic, rules-based investment approaches. They aim to enhance returns or reduce risk by focusing on specific performance factors like value, quality, or low volatility. On the other hand, smart alpha strategies involve active management, where fund managers use their expertise to make investment decisions with the goal of outperforming the market. While smart beta relies on predefined criteria to systematically capture factors, smart alpha seeks to generate excess returns through the active skill and judgment of managers.

How do smart beta funds operate?

Smart beta funds differ from traditional market cap-weighted indexes by following predefined rules to select and weigh securities. Instead of favouring large companies, they give equal weight to all stocks or rank them by factors like return on equity (ROE). This approach provides broad market exposure with a focus on specific performance factors. Smart beta funds also rebalance periodically to maintain their weights, which can lead to higher turnover and trading costs compared to traditional passive funds.

Are smart beta funds considered to be liquid funds?

Smart beta funds are generally considered liquid because they are part of the ETF market, which allows for easy buying and selling. However, their liquidity can be lower compared to more established funds due to their relatively new presence in the market and lower trading volumes. This means it might be slightly harder to quickly buy or sell large quantities of these funds without affecting their price.

Are smart beta funds subject to any tracking errors?

Yes, smart beta funds can experience tracking errors, similar to other passively managed ETFs. Mostly, tracking error occurs when the fund's performance deviates from the index it aims to replicate. Since smart beta funds track specific fundamental indices instead of traditional cap-weighted indices, their returns sometimes differ from the broader market index. This deviation leads to tracking errors which a common challenge for all types of index-tracking funds.

What is the difference between ETF and smart beta ETF?

ETFs (Exchange-Traded Funds) are investment funds that trade on stock exchanges like stocks. They track the performance of an underlying index, such as the Nifty 50. Smart beta ETFs, on the other hand, use alternative index strategies that go beyond traditional market capitalisation weighting. They employ factors like quality, value, momentum, or low volatility to select stocks, aiming to outperform traditional market-cap-weighted ETFs.

Which is the best smart beta fund in India?

Determining the "best" smart beta fund in India depends on your individual investment goals, risk tolerance, and time horizon. Factors to consider include the fund's track record, expense ratio, underlying strategy, and the fund manager's experience. It's advisable to conduct thorough research or consult with a financial advisor to find the most suitable smart beta ETF for your needs.

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The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

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