What are Smart Beta Funds?

Last Updated: 1 Aug 2024

One phrase is gaining popularity and drawing interest from new and seasoned investors in the constantly evolving world of investments: smart beta funds. This financial concept has produced larger potential returns and reduced risk compared to traditional passive index investing. In this extensive tutorial, we set out to grasp what smart-beta funds are, how they operate, and their benefits and potential drawbacks.

Understanding Smart Beta Funds

Before delving into more specifics, it’s critical to understand the origins and goals of smart beta funds. Several restrictions imposed by traditional market capitalization-weighted indexes prompted the development of this idea. These indexes are often used and recognized, however they are not without flaws.

Conventional indexes give firms with higher market capitalizations a greater weight. While this approach has benefits, it might overemphasize pricey stocks and overlook smaller or more inexpensive companies. Developed in response to the need to overcome these constraints, smart beta funds provide an alternative method of building portfolios. They aim to combine the finest features of both active and passive investing by considering factors other than market capitalization.

Additionally, these funds monitor characteristics like value, momentum, quality, low risk, etc. that may be used separately or in combination to create a unique stock selection. For example, a value-based factor investing strategy looks for companies whose share prices are less than their true value per share. Numerous criteria are used in the selection of these companies.

How Do Smart Beta Funds Work?

As previously noted, smart beta funds employ a distinct set of rules-based investment methods that extend beyond the conventional market cap-based approach. A smart beta fund considers several aspects, including revenue growth rate, solvency ratios, dividend yield, PE ratio, etc. In contrast, index funds distribute a larger portion of their money to the stocks of firms with a bigger market capitalization.

For instance, a low volatility smart beta fund may allocate to low beta equities—that is, firms whose price fluctuates less than the market as a whole. Similarly, a momentum smart beta fund may allocate funds to companies that have recently outperformed the market. 

Essential Ideas of Smart Beta

Two main ideas underpin Smart Beta ETF and dictate how they function:

Systematic Factor Exposure
Smart Beta Funds aim to capture particular attributes or variables that affect stock performance. A very wide variety of characteristics, including value, quality, momentum, low volatility, and size, might be included in these considerations. To capitalize on the value component, a Smart Beta Fund, for example, would seek firms with low price-to-earnings (P/E) ratios. These factors might cover many attributes, such as value, quality, momentum, low volatility, and size. 

Rules-Based Approach
Unlike conventional actively managed funds, smart Beta Funds employ an established and open rules-based methodology. This suggests that the fund’s methodology is based on rules or algorithms rather than random human judgment.

Smart Beta Funds With Various Components

Certain smart beta funds concentrate on several aspects. For instance, a multi-factor smart beta fund may put money into firms with robust balance sheets, large dividend yields, and low price-to-earnings ratios.

You might want to look into multi-factor smart beta funds if you seek to factor in different stock risks and strengths while developing your investment plan. Multi-factor smart beta funds offer a more realistic approach and raise the likelihood of a higher outcome by investing in stocks that satisfy many criteria.

The Benefits of a Smart Beta Fund

In India, smart beta funds are provided by a few reputable and well-known financial institutions, such as Share India. Let us now briefly examine their utility. These are just a few of the possible advantages they may provide.

• Diversification: Smart Beta Funds provide advantages over typical market-cap-weighted indexes by focusing on particular aspects.
• Possibility of Improved Returns: By methodically concentrating on variables that have historically produced favorable returns, portfolio performance may be enhanced.
• Public Methodology: Investors can understand how their portfolios are put together thanks to the public guidelines that govern Smart Beta Fund operations.
• Lower Active Management Costs: Smart Beta Funds generally offer lower expense ratios than actively managed funds but are less economical than classic index funds.

Disadvantages of Investing in Smart Beta Funds

There are a few drawbacks associated with smart beta funds:

• Smart beta funds could be more volatile and have less liquidity than conventional index funds. This means that these funds come with some level of liquidity risk.
• Furthermore, a smart beta fund could not beat the market in some circumstances or over specific periods.
• Smart beta funds are more difficult to grasp since their approach is based on variables other than market capitalization.

India’s Top Smart Beta Funds

Over the last five years, the amount of assets invested in smart beta funds has increased annually by 21.5%, indicating rather significant growth for these products internationally. Despite being relatively new, there are currently a number of significant fund firms in India that offer investors access to smart beta products. Among the Smart Beta ETFs and Funds offered in India are the following:

• Edelweiss ETF – Nifty 100 Quality 30
• ICICI Pru NV20 ETF
• Kotak NV20 ETF
• ICICI Pru Nifty Low Vol 30 ETF
• Nippon India ETF NV20
• Sundaram Smart Nifty 100 Equal Weight Fund
• Principal Nifty 100 Equal Weight Fund
• DSP Equal Nifty 50 Fund

Trading Methods

Portfolio managers have a variety of smart beta methods at their disposal. Some people could choose to create or adhere to an index that assigns weights to investments rather than market capitalization.

The Smart Beta strategy is totally based on the demands of the customer or portfolio manager. Adopting a risk-weighted smart beta strategy is an additional choice. Using the risk-weighted technique, an index is created that is solely dependent on future market volatility projections. A manager may, for instance, examine the performance history of an investment to ascertain its potential relationship to future returns and risk.

Conclusion

Consider Smart Beta investing depending on your unique investing objectives and risk tolerance. Smart beta funds are a solid choice for investors seeking a means to lower risk and outperform the market. Before making an investment in any smart beta fund, you should, however, fully grasp the dangers and conduct your own research. Smart beta funds are between actively managed funds and passively managed index funds.

Frequently Asked Questions

What are Smart Beta Stocks?

Beta refers to how a change in individual stock prices affects the stock price as a whole. It helps determine how much the stock market’s volatility impacts a stock’s volatility.

Which Indian Smart Beta Fund is the Best?

This completely depends on your overall portfolio and how well-suited it is. You may utilize a low-risk fund, for example, to balance out the risk in your high-risk portfolio.

Do Smart Beta Funds Carry No Risk?

No, investing in smart beta funds involves a lot of risk. It truly relies on the index it is monitoring and the fund manager’s choice about the distribution of assets. Smart beta funds are subject to market pressures like any other stock market index.

Do Funds that Use Smart Beta have a Significant Tracking Error?

Smart beta funds are not weighted according to market size alone, but rather according to an index. Its performance will thus surely differ from the index it is based on. However, the market’s dynamics and the fund manager’s ability to alter the fund’s structure will dictate how much it outperforms the index.

Are Smart Beta Funds also Called as Liquid Funds?

Since these funds are ETFs, they are regarded as liquid investments. But because they are relatively new to the Indian market, they have lesser transaction volumes, therefore their liquidity might not be very strong.