What Are Smart Beta Funds? A Beginner’s Guide to Smarter Passive Investing

Every equity investor wants to maximise return. However, consistently outsmarting the market without risking wealth may not always be possible. This raises questions about the effectiveness of active investing strategies in generating above-average returns or alpha. As a result, an alternative approach is gaining momentum. Many professionally managed funds are now offering what are known as smart beta funds.

This article explains what are smart beta funds and what you need to know to leverage these strategies effectively in your portfolio.

What is alpha?

In the context of investment and portfolio management, alpha refers to the difference in performance between a portfolio and the benchmark index it is tracking.

For example, assume your portfolio of large-cap stocks has delivered a return of 12% during FY24. During the same period, Nifty50 grew at 8.75%. So, the alpha of your portfolio is (12%-8.75%) or 3.25%.

Mathematically, alpha can be explained by the following equation:

• R = α + βX + U

R = return from the portfolio or stock α = Alpha (The difference of portfolio/stock return against benchmark index) β = Beta X = Benchmark index’s performance U = External and unexplainable factors

What is beta?

Beta measures the volatility of an equity stock or a portfolio of stocks compared to market benchmarks. So, it is the correlation between the performance of the broader market and your stock or portfolio of stocks. The higher the β, the greater the return from your investment following an increase in the underlying benchmark (X as per the equation mentioned in the previous section).

For example, β of your portfolio is 1.2, and Nifty50 delivers a growth of 10%. So, your portfolio will grow by (10%*1.2) or 12%. A portfolio with one β will provide a return in line with the Nifty50. However, a “greater than 1” beta also makes a portfolio more volatile compared to its benchmark market. This brings us to the question of how we can manage β smartly to generate a higher-than-average return without requiring us to manage alpha (α) actively.

What are smart beta funds?

Smart beta funds are index-based portfolios that follow a rule-based investment strategy. Unlike traditional index funds that allocate weights based on market capitalisation, smart beta funds use specific factors to determine stock weightage within an index. The core concept behind smart beta is factor investing, a method that identifies certain traits or factors that historically lead to better returns.

The Nifty50 follows a market-cap-based approach to select stocks. A smart beta fund tracking Nifty50 stocks may still hold the same 50 stocks but assigns different weightages based on selected factors such as value, volatility, or momentum. This introduces an element of active management into an otherwise passive index strategy, hence, the term ‘smart’. Globally, smart beta strategies are most commonly available through exchange-traded funds (ETFs).

What are the factors that influence beta (β)?

Smart beta funds primarily operate through:

• Systematic exposure to beta factors
• Rule-based approach

To manage “systematic exposure”, smart beta funds consider several key factors while constructing their portfolios:

• Value: This factor represents a stock’s intrinsic value, assessed using metrics like earnings per share (EPS), price-to-book ratio, dividend yield, etc. Smart beta funds may give higher weightage to undervalued stocks that have the potential to outperform.

• Market cap: Companies with smaller market caps often offer higher growth potential, albeit with greater volatility. Smart beta funds seeking higher returns may tilt the portfolio towards mid- or small-cap stocks within an index.

• Momentum: Momentum strategies favour stocks that show strong recent performance. Smart beta portfolios may assign more weight to stocks experiencing upward trends, based on the idea that performance can persist in the short term.

• Volatility: This measures how much a stock’s price fluctuates over time. Funds aiming for stable returns might assign lower weights to highly volatile stocks, focusing instead on lower-risk investments.

• Quality: A subjective but critical factor. It includes parameters like return on equity (ROE), debt-to-equity ratio, cash reserves, and promoter holdings. Quality stocks are typically financially sound and better positioned to weather market turbulence.

What is a rule-based investment approach?

Smart beta funds follow a predefined set of rules for portfolio construction based on exposure to the above factors. This removes human biases and emotional decision-making, ensuring consistency and transparency in fund management.

Advantages of a smart beta fund management strategy

Smart beta strategies offer multiple advantages to investors:

• Enhanced risk-adjusted returns: Systematic factor exposure helps reduce downside risk and volatility while maintaining potential for better returns.
  

• Portfolio diversification: Smart beta enables broader diversification beyond traditional market-cap-weighted funds, reducing concentration risk.
  

• Transparency in management: Because the approach is rule-based, investors have clear insights into how and why stock weightages are adjusted.
  

• Cost efficiency: Though not as cheap as pure passive funds, smart beta funds are generally less expensive than actively managed mutual funds, offering a cost-effective middle ground.
  

• Low bias to market psychology: Because factor adjustments are systematic, portfolios are less susceptible to emotional decision-making and market overreactions.
  

Conclusion

Smart beta funds allow investors to earn above-average returns compared to passive index funds without the risk and costs of active portfolio management. However, this strategy also has some disadvantages, including cyclical performance, sectoral biases, and higher costs than pure index funds. So, investors should judiciously choose funds following a smart beta strategy.