Smart Beta Funds - Meaning and Benefits | ICICI Bank

When it comes to investing, there are many options to choose from and one of them is ‘Smart Beta Funds.’ What exactly are these funds and should you consider them in your investment strategy? In this blog, we will explore Smart Beta Funds in simple terms, break down their advantages and disadvantages and help you decide if they are a smart choice for your portfolio.

What is Smart Beta Funds?

Smart Beta Funds are a unique breed in the world of investing. They combine elements of both active and passive investing strategies. In a nutshell, Smart Beta Funds aim to beat the market or achieve specific investment objectives without relying solely on traditional methods. They use a set of predefined rules or strategies to pick and weigh stocks rather than simply mirroring an existing market index like most passive funds. 

How Do Smart Beta Funds Work?

Smart beta funds combine the benefits of passive and active investing. These work on alternative strategies like value, low volatility, quality, or momentum unlike traditional index funds. These funds use a rules-based approach to select and weigh stocks based on specific factors, rather than just market size. This way the funds assist you in reducing risks and boosting gains. By carefully working on performance factors, these funds aim to beat regular index returns while also maintaining low costs and broad diversification. 

Advantages of Smart Beta Funds

Now, let us dive into why Smart Beta Funds might be an attractive option for investors like you:

1. Enhanced diversification: Smart Beta Funds often have a more diversified portfolio compared to traditional actively managed funds. This diversification can help spread risk across various assets, reducing the impact of a single underperforming investment.
2. Lower costs: Smart Beta Funds generally come with lower fees compared to actively managed funds. They aim to provide investors with the benefits of active management without the high expense ratios.
3. Rule-based strategies: These funds operate on transparent and predefined rules, eliminating human emotions from the investment process. This can lead to more consistent decision-making.
4. Specific investment goals:Smart Beta Funds can be tailored to meet specific investment objectives. Whether you are looking for income, growth or value, there is likely a Smart Beta Fund designed to match your goals.
5. Historical outperformance: Some Smart Beta strategies have shown a history of outperforming traditional market indices. They appeal to investors seeking higher returns.

Disadvantages of Smart Beta Funds

While Smart Beta Funds have their merits, they are not without drawbacks.

1. Lack of active flexibility: Smart Beta Funds are not entirely active, so they may not adapt swiftly to changing market conditions or emerging opportunities.
2. No guarantees: Just like any other investment, Smart Beta Funds come with risks and past performance is no guarantee of future results. Some strategies may underperform or experience losses.
3. Complexity: The rules and strategies used by Smart Beta Funds can be complex for the average investor to grasp fully. This complexity can make it challenging to assess whether a specific strategy aligns with your goals or not.
4. Limited track record: Some Smart Beta strategies have a limited track record, making it difficult to evaluate their long-term performance and reliability.

 Types of Smart Beta ETFs

• Equally Weighted

This type of smart beta funds give equal weight to all the stocks in the fund. This way you can get better diversification, and a reduced risk, thereby boosting returns by increasing focus on mid- and small-cap stocks.

• Fundamentally Weighted

These are chosen by companies based on financial measures such as earnings or revenue. This way, you can avoid investing in over-expensive stocks and focus on better stocks that offer long-term and value-driven returns.

• Factor-Based

In this type, the socks are chosen using factors like value, size, or momentum. The focus is on outperforming markets by working on proven return drivers, thereby offering a better option to traditional index investing.

• Low-Volatility

This method invests in stocks with historically low price fluctuations. It targets stable, less risky returns, making it ideal for conservative investors who prefer consistency and protection during market downturns.

Is Smart Beta right for you?

The most important question is, should you consider investing in Smart Beta Funds? The answer depends on your individual circumstances and investment goals.

Smart Beta Funds With Multiple Factors

Smart beta funds with multiple factors work on more than one investing strategy such as value, quality, low volatility, size etc, when selecting stocks. Rather than just keeping focus on factors, they combine multiple factors and in order to balance risks and returns at the same time. For example, a fund may invest in stocks that are both undervalued and less volatile. This blended approach aims to reduce the shortcomings of any single factor and offer more stable performance across different market conditions. 

When Smart Beta makes sense

• Diversification: Smart Beta Funds shine when aiming for a well-rounded portfolio without breaking the bank on fees. They offer a cost-effective way to diversify your investments across various assets.
• Specific goals: If your investment objectives are clear, like targeting value or generating income, Smart Beta Funds can be customised to align perfectly with these goals.
• Risk tolerance: If you are at ease with the inherent risks of investing and have a long-term outlook, Smart Beta Funds can provide a balanced approach, combining elements of both active and passive strategies to suit your risk appetite.

When to be cautious

• Lack of understanding: If Smart Beta strategies are too complex or challenging to understand, it might be best to stick with simpler investment options.

• Short-term goals: If you have short-term investment goals or need liquidity in the near future, Smart Beta Funds may not align with your needs.

• Preference for full control: If you prefer hands-on control of your investments, Smart Beta Funds may not provide the flexibility you desire.

Exploring Smart Beta factors: The building blocks of returns

Smart Beta Funds rely on specific factors to construct their portfolios. These factors are like the secret ingredients that determine a fund's performance. Let us take a closer look at some of these factors and how they are usually captured:

• Value : This factor seeks out low-priced stocks relative to their fundamental value. Metrics like the P/E ratio, P/B ratio, P/S ratio and Dividend Yield are commonly used to identify undervalued companies.
• Dividend yield : Companies with above average and growing Dividend Yields are favoured in this factor. It is all about finding stocks that provide consistent income to investors.
• Size: Market capitalisation plays a key role here. Companies are categorised based on their total or free-float market capitalisation.
• Momentum : Momentum focuses on stocks with strong past performance over the preceding months. It considers point-to-point past returns and historical alpha as indicators.
• Low volatility : This factor targets stocks with below-average volatility. It takes into account metrics like standard deviation, downside standard deviation, beta and more.
• Quality: Quality factors examine stocks with strong profitability characteristics. Metrics like return on equity, return on capital employed, earnings stability, dividend growth, balance sheet strength, low financial leverage, cash flows and more are considered.

Understanding that these factors are not rigid and can vary between Mutual Fund companies is important.

Smart Beta Funds can be a smart addition to your investment portfolio, offering diversification, cost-efficiency and tailored strategies. However, like any investment, they come with unique risks and may not suit every investor. It is essential to assess your financial situation, goals and risk tolerance before deciding whether Smart Beta Funds are the right choice.

How to Invest in Smart Beta Funds?

Investing in Smart Beta Funds in India is similar to regular mutual funds or ETFs. You can invest online through broker platforms, mutual fund apps, or your bank's investment services. Choose a fund based on your risk appetite and preferred strategy—like low volatility, value, or momentum. Study the fund’s objective, past performance, and the factors it follows. You can invest via a lump sum or start a SIP for regular investing. Ensure the fund aligns with your financial goals. Since Smart Beta Funds follow rules-based models, they offer a disciplined investment route with the potential for better long-term returns.