• HDFC securities
• 22 Mar 2022
• Knowledge Centre

A new approach to index investing has gained traction in recent years. Smart Beta is an enhanced indexing strategy that aims to leverage certain performance factors to try to outperform a benchmark index. This makes it fundamentally different from a traditional passive indexing strategy.

Smart Beta ETFs work on the same strategy, and they are thriving in the global market. Total assets invested under Smart Beta ETFs and ETPs reached a record $1.12 trillion globally by the end of March 2021, a 12.5% increase YTD in 2021. Thus, options for investors today are not limited to just plain vanilla schemes. In India, Smart Beta Fund strategies based on value, low volatility, and a combination of alpha and low volatility have attracted interest from investors.

But how are these ETFs different from the traditional passive ETFs? It’s important to understand the differences to find out whether Smart Beta Funds could be suitable for you.

Smart Beta ETFs For Intelligent Portfolio Diversification

Smart Beta ETFs use a combination of active and passive styles. The investment style is rule-based (active), while the investment philosophy is passive. Certain well-researched factors are used to select and weigh stocks in creating an index portfolio. The strategies passively follow indices, but also take other things into account, such as quality, liquidity, value, and momentum. For instance, a Smart Beta ETF that tracks NIFTY 100 won’t select every stock on the index, but only those that satisfy a rule or factor such as X% of revenue growth.

In contrast, traditional ETFs are passively managed tied to an index or underlying market sector. There, the allocation of assets is simply based on market cap.

Smart Beta ETFs could allow you to allocate your money more smartly. They could allow you to avoid fund-manage risk while keeping exposure to certain desirable factors. The aim is to enhance returns and reduce risks. This means a more targeted risk and returns profile.

Variety of Strategies in Smart Beta

There are many strategies popularly used for Smart Beta ETFs, including equal weighting assets, the momentum of a stock, estimated future volatility, dividend yield, and underlying fundamentals like book value or P/E ratio. Only those holdings that fit the rules will be included in the portfolio for a particular ETF. Smart Beta strategies allocate and modify portfolio holdings based on these factors. So, stocks of companies that have strong balance sheets, stable cash flows, higher profits, can be considered in the index. Different factors may perform well at different times.

This is in contrast to the usual capitalisation-weighted ETFs, where stocks with higher market cap are weighted more heavily; as a result, only a handful of highly-valued stocks end up accounting for a large percentage of the total value of the index.

Smart Beta ETFs could be an option for you to maximise your income potential and minimise risk. However, it’s important to know that they have higher expense ratios than passive ETFs. But, they are cheaper than most actively managed funds.

Which Should You Choose?

Smart Beta Funds are still a new asset class in India, which is why you need to be aware of lower liquidity compared to passive ETFs. There is limited data to compare and analyse these funds. With the development in market understanding, there could be an increase in investments in these types of ETFs. Smart Beta Funds could be a good option for you, but you need to decide after evaluating all information.

A huge portion of a portfolio’s return is determined by allocation, rather than a selection of securities or timing. Consider diversifying across various investment styles. You could choose Smart Beta ETFs and active funds, to play each style according to your preference