All you need to know about smart beta investing

Smart beta investment strategies are gaining popularity and aim to provide better returns in the long term than the broad market. Smart beta strategies are used by some index funds and exchange-traded funds (ETFs),

Smart beta index funds and ETFs mirror market indices that select stocks based on certain qualities or ‘factors’, such as value, momentum, quality, low volatility etc.

Smart beta strategies aim to combine the cost-effectiveness of passive investing with the potential for better long term returns than the broader market.

• Table of contents

• Smart beta funds meaning
• The working of smart beta funds
• Key principles of smart beta funds
• Performance of smart beta funds
• Advantages of smart beta funds
• Disadvantages of smart beta funds
• Factors affecting smart beta funds
• How to invest in smart beta funds?

Smart beta funds meaning

Smart beta strategies are used in factor-based funds, are passively managed funds that track indexes designed on certain ‘factors’ or qualities rather than traditional market capitalisation weighted indexes.

Smart beta investing aims to capture better returns over the broad market by focusing on indices that select stocks based on certain factors or rules such as value, size, quality, momentum, low volatility etc. This results in a portfolio that looks different from a broad market index such as Nifty50 or BSE Sensex, where stocks are given proportionate representation based on their market capitalisation.

The goal of smart beta strategies is to provide better risk-adjusted returns compared to traditional index funds by relying on these factors that basically indicate the attributes or growth potential of the underlying stocks.

The working of smart beta strategies

Smart beta strategies are adopted by some passively managed funds, replicating a stock market index. However, instead of traditional market indices, such funds replicate factor-based indices.

Here are some kinds of indices used for smart beta strategies:

• Value indices that focus on stocks trading at a discount to intrinsic value metrics like book value, earnings, sales etc.
• Low volatility indices that emphasise stocks with lower historical return variance.
• Quality indices that select stocks with strong balance sheets and profitability track records.
• Momentum indices that comprise stocks have been going up in value in the recent past and are expected to continue to do so in the near term.

Key principles of smart beta funds

• Reliance on alternative weighting schemes rather than market capitalisation-based indexing.
• Follows rules-based passive management rather than active stock picking.
• Lower costs than actively managed funds due to the passive approach, with better return potential than broad-market passive funds.
• Targets specific factors or a combination of factors that drive performance.
• Aims to capture excess returns over market cap weighted benchmarks over the long run.
• May diversify across sectors and market caps to reduce concentration risks.

Performance of smart beta strategies

Smart beta strategies have the potential to outperform market cap weighted benchmarks over the long term. However, they may also be riskier than broad market-based funds as performance depends significantly on the specific strategy used.

Smart beta strategies carry risks like factor underperformance, concentration in particular sectors, or exposure to unintended factors. Performance also varies based on market conditions.

Advantages of smart beta investing 

• Potential for better risk-adjusted returns compared to market cap-weighted index funds over the long term.
• Rules-based transparent approach rather than subjective active stock picking.
• Lower costs than actively managed funds.
• Mix of active and passive investing by targeting factors while being index-based.
• Allows tactical factor timing and rotation strategies for seasoned investors.

Disadvantages of smart beta investing

• Excess returns are not guaranteed and depend on factor performance.
• May underperform market cap weighted benchmarks, especially over shorter periods.
• Concentration risks from alternative weighting schemes.
• Lack of consistent long term track record for newer strategies.
• Complicated construction methodologies make evaluation tough.

Factors affecting smart beta strategy

• Market conditions: Performance varies based on market trends; some factors (e.g., momentum) tend to perform better in bull markets, while others (e.g., low volatility) may be more beneficial in downturns.
• Factor selection: The chosen strategy (e.g., value, momentum, quality, low volatility, dividend yield) significantly influences risk and return potential.
• Inflation: Inflation affects different factors uniquely.
• Liquidity: Some smart beta strategies involve stocks with lower liquidity, which can lead to higher trading costs and price impact.
• Fund expenses: Though they generally have lower costs than active funds, smart beta funds may have slightly higher costs than traditional index funds.
• Sector exposure: Some factors may lead to sector concentration, which increases risk (e.g., a momentum strategy might be overweight in tech stocks).

How to invest in smart beta funds?

• Analyse historical performance* across market cycles, especially drawdowns (*Past performance may or may not be sustained in the future)
• Evaluate fund methodology and assess if it sticks to its objective
• Assess factor exposures to determine risks and diversification
• Start small with a tactical allocation, rather than core holding
• Diversify across factors and complement with active funds
• Rebalance periodically and use for tactical factor timing

Conclusion

Smart beta investing offers a rules-based approach to aim for excess returns over traditional indices in the long term. They aim to bridge the gap between active and passive investing. However, factor performance tends to be cyclical. Hence, funds with a smart beta strategy may carry more risks than broad-market funds. Be sure to understand the factor-based approach used by the fund and align it with your risk appetite and investing approach.

FAQs:

Is the expense ratio lower in smart beta funds?

Being passively managed, funds with smart beta strategies may have lower expense ratios than actively managed funds. However, their expense ratios may be higher than that of traditional index funds due to greater complexity and higher turnover.

Are smart beta funds subject to any tracking errors?

Yes, like all passive funds, funds following smart beta strategies can experience tracking errors.

Are smart beta funds considered to be liquid?

Smart beta investing funds focused on large and mid cap stocks maintain adequate liquidity. But some niche funds holding small caps or using complex methodologies may have lower liquidity.

Who should invest in smart beta?

Investors with a high-risk appetite looking for better long term return potential over market cap weighted funds may consider smart beta investing. They are also suitable for tactical factor timing.

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

Smart beta funds are passively managed, but the indices they are based on are built on certain rules or factors that make them distinct from market capitalisation-weighted indices. Thus, they seek to provide a blend of active and passive objectives.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.