Introduction to Smart Beta Funds: India has nearly 9 crore systematic investment accounts. Popularly known as SIPs, this strategy is widely followed by retail investors in India to invest in mutual funds, including index funds or passive investing. The number of SIP accounts has jumped from around 5.3 crore two years ago, indicating rising awareness among investors.
Retail investors in India have come a long way. From sticking only to bank fixed deposits, they are now increasingly looking at stock markets and mutual funds for wealth creation. These investors are also getting savvy, thanks to social media and new-age fintech companies that have not only made investment easier but also helped them in identifying suitable investment approaches.
Investors are no longer waiting for some expert to suggest mutual fund schemes. Many of them are starting investments by simply choosing index funds.
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The passive style of investing, which mainly involves investments in index and exchange-traded funds, has gained popularity. Compared to active funds, where investors rely on the expertise of a fund manager to pick stocks to generate higher returns, passive funds simply follow an index, such as Nifty 50 or Sensex. Hence, they are low-cost and easy to understand. Despite charging a comparatively higher management fee, active funds do not always outperform the benchmark. On the other hand, passive or index funds by definition are supposed to match the performance of indices.
In a sustained bull market, some experts often complain that they have missed out on the stocks that have given higher returns because those companies were not part of the underlying index or had lower weightage. Is there a way for investors to continue putting their money in index funds and yet earn returns that outperform the index? Smart beta funds are the answer.
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How Do Smart Beta Funds Work?
Smart beta funds are a type of mutual fund that is gaining attention. This category is growing steadily. Smart beta funds offer the best of both worlds by blending active and passive investment strategies. It works as a passive investment vehicle by adopting a market-cap-based index, such as Nifty 50 or Sensex. Basically, it uses stocks from broader market indices and then filters them based on specific active investment strategies or factors. The six well-known factors are value, volatility, momentum, quality, size, and dividend yield.
How Do Smart Beta Funds Differ from Traditional Passive Funds?
Just like any traditional index fund, smart beta funds also track an index. But the difference is in the way a particular stock or company is assigned weight. Usually, the fund manager for a particular index fund will assign weights based on the underlying index. Hence, companies with higher market cap get higher weightage. On the other hand, smart-beta funds will not rely solely on market cap; instead, they will deploy these six scientifically designed methodologies, either in isolation or in combination, to assign weights to stocks that have the potential to generate higher returns.
For example, let’s take Nifty200 Momentum 30, which is an index that tracks the performance of 30 high-momentum stocks across large and mid-cap categories within the universe of Nifty 200 companies. Similarly, the Nifty 100 Low Volatility index will fund 30 of the least volatile stocks among the Nifty 100 companies.
In a momentum strategy, fund managers focus on taking advantage of the market trend by buying and selling stocks that are rising and selling them when they have peaked. On the other hand, low-volatility stocks aim to protect investors on the downside and are more suitable for conservative investors.
Is Smart Beta ETF Active or Passive?
To put it simply, smart beta ETFs offer investors the best of both passive and active investing. Just like index funds or ETFs, they have advantages such as low cost because of lower fund management fees and exposure to diversified sectors, which plays a big role in minimizing risks. At the same time, they aim to provide benchmark-beating results like active funds.
What are the advantages of investing in Smart Beta?
Benchmark Beating Results
By following a scientific methodology in stock selection, smart-beta funds have the advantage of being devoid of any active management. The outlined strategies such as value, momentum, size, quality, low volatility, and dividend yield are designed to provide higher returns than the broader market.
Low Cost
Just like index funds, smart-beta funds are also low-cost because there is not much active fund management, and hence the expense ratio tends to be lower compared to traditional active funds.
Diversification
Broader market indices are usually made up of companies across various sectors, and hence smart beta funds get exposure to different companies, thereby reducing risks associated with investing in securities from one sector.
Wrapping Up
Conclusion
As discussed above, there are several advantages of investing in smart beta funds. However, investors must understand that these funds are cyclical in nature, meaning the success of a particular factor strategy hinges on overall market conditions. Hence, investors must not always expect that a particularly deployed factor strategy will work. Smart beta funds, while gaining popularity, are also relatively new. In a short period of time, most of the funds have given higher returns. But past performance does not guarantee future returns. Usually, the performance of the new category of funds over a market cycle is one of the key parameters to look out for.
FAQs
What are smart beta funds?
Smart beta funds are a type of mutual fund that blends both passive and active investment strategies. They track a market-cap-based index like Nifty 50 or Sensex but use specific factors such as value, volatility, momentum, quality, size, and dividend yield to filter and weight the stocks within the index.
How do smart beta funds differ from traditional index funds?
While traditional index funds assign weights to stocks based on market capitalization, smart-beta funds use additional factors to assign weights. This approach aims to enhance returns and manage risks better than traditional index funds.
What are the common factors used in smart beta funds?
The common factors used in smart beta funds include value, volatility, momentum, quality, size, and dividend yield. These factors are selected based on historical performance and theoretical foundations in financial research.
Are smart beta funds more expensive than traditional index funds?
Generally, smart-beta funds have slightly higher fees than traditional index funds due to the additional layer of strategy and analysis involved. However, they are typically less expensive than actively managed funds.
What are the benefits of investing in smart beta funds?
Benefits include the potential for higher returns compared to traditional index funds, better risk management through diversification across factors, and lower costs compared to actively managed funds.
What risks are associated with smart beta funds?
Smart-beta funds can be cyclical, meaning their performance may vary with market conditions. There is also a risk that the chosen factors may not perform as expected, leading to underperformance.
Can smart beta funds outperform traditional index funds?
Smart-beta funds aim to outperform traditional index funds by using specific factors to enhance returns. While they have the potential to outperform, this is not guaranteed, and performance can vary over different market cycles.
How do I choose the right smart beta fund?
Choosing the right smart-beta fund involves understanding your investment goals, risk tolerance, and the specific factors used by the fund. It’s also important to review the fund’s historical performance, fees, and the reputation of the fund manager.
Are smart beta funds suitable for all investors?
Smart-beta funds can be suitable for a wide range of investors, particularly those looking for a middle ground between passive and active investing. However, investors should be aware of the risks and ensure that the fund’s strategy aligns with their investment goals.
How can I invest in smart beta funds?
You can invest in smart-beta funds through most financial institutions, including banks, brokerage firms, and online investment platforms. It’s advisable to consult with a financial advisor to ensure that smart-beta funds fit into your overall investment strategy.
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