Smart Beta Funds: The What, How, and Why of These New-Age Mutual Funds

The first ETF (Exchange Traded Fund) was launched in India in the early 2000s. Fast forward to the present, and we now have more than a hundred ETFs. Over the years, these passively managed funds that replicate market indices have been a favourite among risk-averse investors.

While ETFs perfectly match the investment needs of several investors, they have their limitations. One of the most significant of them is their limited returns potential. If you prefer investing in passively managed ETFs but looking for higher potential returns, then you should consider adding smart beta funds to your portfolio.

Here’s everything you should know about these new-age ETFs-

What are Smart Beta Funds?

Smart beta mutual funds take the current ETF model a significant step forward. While these are passively managed funds, rather than entirely tracking market capital weighted indices such as Sensex or Nifty50, they follow certain factors or formulas to build the asset portfolio.

For instance, within Sensex, the scheme will dig deeper only to choose stocks that fully satisfy the factors around which it is created to generate higher returns than Sensex.

Smart beta funds follow the factor investing methodology, wherein factors such as quality, value, momentum, risk, etc. are used in combination or isolation for creating a unique basket of assets. Like ETFs, these mutual funds have a lower total expense ratio.

How Do Smart Beta Funds Work?

Smart beta funds customize the underlying benchmark based on certain factors to select securities and decide their weightage.

For instance, if the scheme follows a quality-based investing methodology, then stocks will be selected based on factors such as earnings stability, return on equity, cash flows, dividend growth, financial leverage, and balance sheet. Similarly, value-based investing will involve factors like P/E (Price-to-Earnings) ratio, P/B (Price-to-Book) ratio, dividend yield, etc.

It is also worth noting that the factors such as quality, value, momentum, volatility, etc. are defined by the fund houses and are not standardized. Thus, a quality stock for one fund house might not be treated as the same by another fund provider.

What are the Benefits of Investing in Smart Beta Funds?

In several ways, smart beta funds have successfully bridged the gap between passively managed funds and actively managed mutual funds. While these funds also track an index, the index is modified with the aim to reduce volatility or generate higher returns.

Here are some of the top reasons to add smart beta funds to your investment portfolio-

• Potential to generate returns higher than traditional ETFs
• While the risk profile of certain smart beta ETFs can be higher, they are still considered low-risk investments
• The funds offer access to an extensive range of investment strategies that can help investors build a diversified portfolio
• Higher expense ratio compared to traditional ETFs but still lower than active funds
• Funds follow a fixed investment strategy/modified index and are free from any bias from the fund manager, just like ETFs

Are There Any Disadvantages of Investing in Smart Beta Funds?

While smart beta schemes can be an ideal alternative to traditional ETFs for investors who want to generate higher returns, there are some disadvantages too. Take a look-

• Not the best choice for risk-averse investors as the schemes are riskier than traditional ETFs.
• As smart beta schemes are still new in India, their trading volume and liquidity are low.
• Like ETFs, these schemes track a specific index, due to which they are also prone to tracking errors.
• The expense ratio is higher than traditional ETFs

Should You Invest in Smart Beta Funds?

If you prefer the passive management style of ETFs but are looking for potentially higher returns without shouldering the higher risk profile of active funds, then smart beta funds can be an excellent addition to your portfolio. These schemes have lower expense ratios than active funds but can still beat their benchmarks and deliver higher returns.

But as smart beta schemes are relatively new in India, investors are advised to proceed with caution as the amount of data used to analyze and compare fund performance is fairly limited. If you are new to investing, then it’d be wise to consult with an investment advisor before investing in these funds.


DISCLAIMER

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.