What are Smart Beta Strategies?

Risk-averse investors generally use index funds or similar methods to invest in the stock market. It helps them to avoid volatility and also gain moderate returns. Certain investment help such investors to get the return of active investment while being passively invested in the market. One such strategy is called the smart beta strategy.

Beta is a value that measures the volatility of a particular stock with the overall market. The volatility of the market can be measured using benchmark indexes. In the last few years, a new concept named ‘smart beta’ has started gaining attention.

The economist Harry Markowitz first theorized the concept of Smart Beta through ‘modern portfolio theory. This article spotlights Smart beta strategies and their popularity.

What is Smart Beta Strategy?

Smart beta strategies are the upgraded version of the conventional index investing strategies. Smart Beta strategy is a rule-based active management of passive investing that aims at outperforming market-cap-weighted indexes. As the portfolio is constructed based on a particular mechanism, human bias is eliminated. They aim to beat benchmark indexes either by increasing the return or by reducing the risk.

While traditional passive investing involves investing the funds directly in the benchmark index, Smart beta strategies involve the use of one or more performance factors, other than market capitalization, to reconstruct a portfolio. Performance factors means those characteristics that form the basis of stock inclusion in a particular basket. Some of the factors the smart beta exploits are value, quality, volatility, momentum, size, and so on.

One of the issues with investing in the benchmark index is that most of them contain stocks based on larger market capitalization. Additionally, their weightage in the index also depends on their market capitalization. When those stocks are larger, they may have high volatility or higher than intrinsic value. Smart beta strategies solve this problem.

Smart Beta is gaining more traction since it provides customized indexes at a lower cost than actively managed portfolios. These strategies are used for varied asset classes such as equities, commodities, fixed income, and a combination of asset classes.

Smart Beta Funds

Smart Beta funds are those funds that have alternative ways of weighting the indices than benchmark indices. Smart-beta funds follow one or more performance factors to create a unique portfolio. The index created depending on different factors is backtested first.

For example, Nifty alpha low volatility 30 is one of the multi-factor smart-beta funds. This index reflects the performance of 30 stocks that beat the market in terms of return and are relatively less volatile.

Another smart beta fund is the Nifty alpha quality low volatility 30. This index tracks the performance of 30 stocks that outperformed the market, have strong profitability characteristics and are relatively less volatile.

A company can be part of one or more funds at one or another point in time. For example, SBI Life insurance can be a part of quality stock at one time and momentum at another. Even a company can be a part of two different smart fund indexes at the same time.

Selecting Smart Beta Strategies

The Investment strategies are like the size of clothes. There is no single best smart beta investment strategy that fits all the investors. They have different preferences of risk and return and choose the strategy accordingly. Some may choose ‘Value’ as the performance factor and seek the index that states undervalued stocks. Others may find ‘momentum’ as the best performance factor and follow the index that contains the stocks that best performed in the last 3-6 months.

Alternatively, some risk-averse investors may prefer the index that contains the stocks having lower future volatility. The investors can also choose multiple factors to reconstruct and reestablish the index. For instance, an index containing those stocks which provide higher dividend yield and lower volatility.

Smart Beta Popularity

Over time, smart beta has gained wild popularity, since investors are not satisfied much with conventional strategies. According to ETFGI’s Smart Beta industry landscape report, the assets invested in Smart Beta ETFs and ETPs accounted for US$1.22 trillion at the end of May 2021 globally. There were 1316 smart beta equity ETFs/ETPs, with 2601 listings, assets of $1.22 Tn, from 195 providers listed on 45 exchanges in 37 countries, at the end of May 2021, according to the same report.

Smart beta is considered an efficient investment strategy but does not guarantee to outperform the market. Moreover, some of the factors that smart-beta funds track do not have standardization. For instance value, quality, etc. Thus, investors cannot completely rely upon these strategies.

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Frequently Asked Questions Expand All

A smart beta portfolio construction requires selecting one or more asset classes, performance factors, type of assets, and accordingly eligible stocks or commodities.

Though smart beta and factor investing are used interchangeably, there is a significant difference. Smart Beta funds have considerable correlations with the stock market whereas, factor portfolios have negligible correlations with beta.

Even if smart-beta funds are highly popular, they are not risk-free. There exist some risks such as lower liquidity, lack of standard variable, higher expense ratio, higher portfolio turnover, and many others.