Smart Beta Funds

Smart Beta Funds is an investment strategy that has gained popularity among investors in recent years. These funds are designed to provide an alternative to traditional market-cap weighted index funds by using a rules-based approach to selecting and weighting stocks. Unlike traditional passive index funds, smart beta funds aim to outperform the market by focusing on specific factors such as value, momentum, and quality. 

In this article, we will explore what are smart beta funds, advantages and disadvantages of smart beta funds and provide insights on whether they are the right fit for your investment portfolio.
 

What are Smart Beta Funds?

Smart Beta Funds, also known as factor-based or strategic-beta funds, refer to those investment funds that use a non-traditional weighting methodology instead of the traditional market-cap weighting to create a unique portfolio of stocks. These funds follow factors such as value, momentum, quality, low risk, etc., to select stocks and create a unique basket of securities. 

Unlike passive funds, Smart Beta Funds are actively managed and aim to outperform the market. For example, a value-based Smart Beta Fund may use metrics like PE ratio, PB ratio, price to sales, dividend yield, etc., to identify companies whose stock price is lower than their intrinsic value per share. By incorporating factor investing, Smart Beta Funds seek to attain higher risk-adjusted returns than passive funds.
 

How Do Smart Beta Funds Work?

Smart Beta Funds use a unique investment approach that combines the benefits of both active and passive investing strategies. These funds track an index like passive funds but select and weigh securities based on specific methodologies. The index is customised using a few underlying factors that are used to select and weigh the index securities.

The factors used by Smart Beta Funds are not standardised, and some funds are based on just one factor, while others are based on two or more, also known as multi-factor funds. For example, the Nifty Alpha Low Volatility 30 is a multi-factor smart beta that uses a combination of factors to construct its portfolio.

The following table provides a comprehensive overview of the various factors used by Smart Beta Funds and the metrics used to capture each factor:
 

Smart Beta Funds With Multiple Factors

Smart Beta Funds with Multiple Factors offer investors a unique way to diversify their portfolio while still maintaining a passive investment strategy. These funds combine multiple factors to create a basket of stocks that aims to deliver superior returns compared to a single-factor strategy. The table below shows some of the popular indices that use a combination of up to four factors:

Investors often believe that a multi-factor Smart Beta Fund performs better than a single-factor fund. To test this assumption, we need to examine the performance of Smart Beta indices and analyse their risk and return.

Performance Of Smart Beta Funds – Returns And Risk

Smart beta funds in India on the NSE have outperformed the NIFTY 50 index in the last 5 years, with 9 out of 16 indices generating better annualised returns than the benchmark index. Among Smart Beta indices, single-factor indices have delivered higher returns compared to multi-factor indices, which often prioritise risk reduction. However, single-factor indices also come with a higher level of volatility. The following two tables provide a comprehensive overview of the 5-year returns and performance of Smart Beta indices on the NSE.

5-Year Returns Of Smart Beta Indices

5-Year Performance Of Smart Beta Indices

Smart Beta Funds – Merits And Concerns

Smart Beta Funds in India have gained popularity among investors due to their ability to offer a rules-based approach to investing. This strategy is relatively transparent and easy to understand compared to active investing, which can be subjective and prone to emotional biases. Moreover, smart beta can help with diversification and reduce portfolio volatility, thus managing risk effectively. Another significant advantage of Smart Beta Funds is their low expense ratio compared to actively managed funds, leading to cost savings for investors.

However, one of the primary concerns is the lack of data on factor indices, which makes it challenging to evaluate the performance of smart beta in persistent market corrections. The data available for Indian markets only includes a couple of significant market corrections like 2008 and 2020, which raises concerns about the reliability of this strategy. As a result, investors must weigh the merits and concerns of Smart Beta Funds before investing.
 

Should You Invest In Smart Beta Funds?

Smart Beta Funds can be an attractive option for investors looking for a cost-effective way to potentially achieve above-market returns. By allocating a portion (15-25%) of your portfolio to Smart Beta funds, you can diversify your investments and reduce overall portfolio volatility. However, keep in mind that these funds need to be monitored regularly as market conditions and factors may change. Additionally, investors should be cautious and avoid investing all their assets in Smart Beta Funds alone. As with any kind of investment strategy, it is crucial to maintain a diversified portfolio in order to reduce risk.

Advantages of Smart Beta Funds

Smart Beta Funds have several advantages over traditional exchange-traded funds (ETFs) and actively managed funds. 

●    Firstly, they provide diversification of portfolio through a range of strategies like equal weightings and fundamental weightings. This allows investors to have customised holdings that can benefit their portfolios. 
●    Secondly, Smart Beta Funds are low-risk investments since they follow the performance of the index, making them a good option for investors seeking to maximise their returns and minimise risk. 
●    Thirdly, they have lower expenses than actively managed funds, while still providing higher returns than traditional ETFs. 
●    Finally, Smart Beta Funds provide increased returns by modifying the index composition to include stocks that are high quality and have high growth potential.
 

Disadvantages of Smart Beta Funds

Investing in Smart Beta Funds can provide a range of benefits, but it's important to also be aware of the potential drawbacks. Some of the disadvantages of Smart Beta Funds include:

●    As smart beta or factor funds are still relatively new in India, the trading volume of these funds is lower compared to more established funds. This can result in lower liquidity and impact the investor's ability to sell their holdings at the real market value.
●    Along with lower trading volumes, the liquidity of Smart Beta Funds may also be impacted, making it harder for investors to buy or sell at their desired price.
●    Smart Beta Funds tend to have higher expense ratios, which can eat into returns. Additionally, they may be more expensive to rebalance and have higher portfolio turnover, leading to additional transaction costs.
 

Conclusion

Smart Beta Funds are a relatively new investment approach in India that provides investors with a range of strategies to diversify their portfolios, minimise risk, and potentially increase returns. With a better understanding of Smart Beta Funds meaning, investors can make informed decisions on whether to invest in these funds. However, it is essential to consider the drawbacks such as liquidity issues and higher costs. As with any investment approach, thorough research and due diligence are crucial. Smart Beta Funds India has a lot of potential, and with the right approach, investors can benefit from this innovative investment strategy.