Smart Beta Funds: Characteristics, Factors, Benefits, and Limitations

Do you ever feel stuck between the world of active and passive investing? While active funds claim to give a market–beating returns but often come with high fees and underwhelming results, passive funds, while being cost-effective, just mirror the market and provide average returns. 

Not anymore! In today’s blog, we will explore smart beta funds, a strategic blend of active and passive funds that might be the perfect fit for your portfolio. 

What are Smart Beta Funds?

Smart Beta Funds, also referred to as factor-based strategic beta funds, actively select, weigh, or combine factors believed to contribute to higher returns and reduced risk, aiming to outperform traditional market-capitalization weighted index funds. They capture specific investment strategies historically associated with outperformance.

Let’s understand this with an example.

If you believe undervalued stocks have the potential for future growth, a smart beta fund focusing on value might include companies with low PE ratios or high dividend yields. These could be companies with a strong fundamental track record.

Smart Beta Funds Characteristics

• Factor Investing

These funds emphasize specific factors that are believed to drive returns. Common factors include value, size, low volatility, quality, etc.

• Rules-based Method

Unlike actively managed funds, smart-beta funds generally follow a rule-based methodology along with a systematic, transparent investment process that is based on predefined criteria for factor selection.

• Low-Cost

Similar to traditional index funds, smart-beta funds often have lower expense ratios when compared to actively managed funds.

• Customization

Smart beta strategies can be tailored to specific investment goals or risk preferences. Investors can select funds that align with their objectives.

Note – While smart beta funds may outperform traditional market-cap-weighted indices, performance can differ based on market conditions.

Factors of Smart Beta Funds

Smart Beta Funds rely on a specific set of factors to choose and weigh holdings within the fund, deviating from the traditional market capitalization method. Here are some of the most common factors used in smart beta investing.

• Value – this factor focuses on stocks that appear to be undervalued and have a low P/E ratio and relatively high dividend yields. Thus suggesting that they have the potential to grow.
• Momentum – the factor targets stocks that have been experiencing strong price movement recently, based on the assumption that the trend is likely to continue in the future.
• Quality – This factor focuses on companies with strong financial attributes like profitability, low debt levels, and a stable cash flow because these companies are considered less risky and more likely to perform consistently over time.
• Low Volatility – this factor focuses on seeking stocks with lower betas, which means that their price movements tend to be less volatile than the overall market. This can help in navigating the portfolio risk.
• Size – Size refers to a company’s market capitalisation. Some smart-beta funds might focus on small-cap or mid-cap stocks, believing that they carry a high-growth potential compared to large-cap companies.

These factors are not necessarily used alone. Many Smart beta funds combine multiple factors in their selection criteria to achieve specific risk-return objectives.

Benefits of Smart Beta Funds

1. Smart Beta Funds provide exposure to specific investment factors which allow investors to earn higher returns. For example – by including stocks with less dramatic price swings, the overall portfolio’s risk is reduced. 
2. Smart Beta strategies incorporate a diversified portfolio and spread risk across different sectors.
3. Compared to actively managed funds that need human stock pickers, smart-beta funds come with a lower expense ratio.
4. Since these funds function based on predefined objectives, it provides transparency to investors and helps them understand the fund’s strategy.

Note – It is important to keep in mind that smart beta is not a guaranteed path to riches.

Limitations of Smart Beta Funds

1. Past performance is not necessarily indicative of future results, and there is no assurance that a smart beta fund will outperform the market.
2. These funds are still exposed to several risks. For example, value-focused funds might not outperform if value stocks move in an unfavourable position.
3. Some smart beta strategies may have a limited track record, especially if they are based on relatively new or niche factors. 
4. There is no consensus on which factors are the most effective for generating alpha or excessive returns. Therefore, choosing the wrong factor fund may cause losses.

Performance Analysis of Smart Beta Funds

The chart below showcases the performances of several factor indices over the past few years.

A brief explanation of the above-mentioned indices:

NIFTY Alpha Low-Volatility 30 Index 

This index is curated to reflect the performance of a portfolio of stocks selected based on a combination of Alpha and Low Volatility. This Index consists of 30 stocks selected from the Nifty 100 and Nifty Midcap 50.

NIFTY Alpha Quality Value Low-Volatility 30 Index 

This index is curated to reflect the performance of a portfolio of stocks selected based on a top combination of Alpha, Quality, Value, and low volatility. The Index consists of 30 stocks selected from the Nifty 100 and Nifty Midcap 50.

NIFTY Alpha 50 Index 

This index aims to measure the performance of securities listed on the NSE with high alphas. It is a well-diversified 50-stock index. Criteria such as liquidity and market capitalization are applied while selection of securities.

NIFTY Alpha Low Volatility 30

This index is curated to depict the performance of a portfolio of stocks selected based on the top combination of alpha, quality, and low-volatility.

Furthermore, several other indices such as the Nifty 100 Equal Weight, Nifty 50 Arbitrage Index, Nifty200 Momentum 30 Index, Nifty High Beta 50 Index, and Nifty 50 Equal Weight are also used to track the smart beta funds. 

Did You Know?

Nifty Multi-factor indices are created to showcase the performance of a portfolio of stocks that are selected based on a combination of 2 or more factors. 

Conclusion

To wrap it up, smart-beta funds offer a compelling proposition for investors seeking a cost-effective and performance-enhancing alternative to traditional index funds, and understanding their benefits and drawbacks can help investors make better investment decisions. 

However, before investing, keep yourself updated on the latest trends and do not rely solely on smart beta strategies. 

Frequently Asked Questions (FAQs)