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 represent a departure from conventional market-cap weighted indexes. They utilise a different approach, focusing on factors like value, quality, momentum, low volatility, and size, to construct portfolios. By deviating from standard indices, smart beta funds aim to capture specific market factors to potentially enhance returns and manage risk.
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.
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Key principles of smart beta funds
Smart beta funds operate based on two fundamental principles:
- Systematic factor exposure
- 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.
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.
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.
