While investing in the stock market we might have often heard about ETFs or exchange traded funds. A standard ETF, like one that tracks the Nifty 50, which is like a basket of stocks where the biggest companies get the biggest share. This is simple, but it means you end up putting more money into stocks that are already large and popular.
But what if you can invest in more smarter ways and build a smarter basket. This is where the smart beta ETF is for, instead of just focusing on a company’s size, a smart beta ETF picks and weighs stocks based on other specific traits or “factors”, like whether a stock is undervalued, has stable earnings, or pays good dividends. It’s a strategic approach that blends the low-cost, rule-based nature of a passive ETF with the intelligent stock-picking ideas of active investing.
What is an ETFs?
Exchange Traded Funds, or ETFs are a basket of stocks where instead of buying one share of one company, you buy one unit of an ETF that has small pieces of many companies at once, making your investments diversified and not concentrated in just one or two stocks. It’s a simple way to get diversification and usually comes with lower fees.
Generally, ETFs that track the Nifty 50 choose companies based on their size, or market capitalization. Market cap is calculated by multiplying a company’s share price by the total number of shares it has. This method is called “market-cap weighting.” In such ETFs, bigger companies get a larger share of the basket. That’s why a large company like Reliance Industries affects the Nifty 50’s performance much more than smaller companies in the index.
What are Smart Beta ETFs?
Smart ETFs are an investment product that fall in between purely investing in Nifty 50 ETF and fully active investing in selected stocks. Index is used for benchmarking in Smart Beta ETF. A smart beta fund tracks an index, just like a regular ETF, but the main focus is not only on the market cap, it is built using a transparent, rules-based system that focuses on specific characteristics or factors, which is the main idea behind Smart Beta ETFs.
The rules used for these Smart Beta are pre-defined that are followed automatically. For example, a rule might be, “From the Nifty 100 stocks, only select companies that have low debt and stable earnings.” This makes the process transparent and removes emotional decision-making.
Smart Beta ETF is now becoming popular amongst the investors and the options for these alternatives in India are growing as smart beta takes the proven ideas that expensive active fund managers have used for years and puts them into an automated, low-cost, and transparent ETF format.
Read Also: Smart Beta Funds: Characteristics, Factors, Benefits, and Limitations
Factors Affecting Smart Beta ETFs
- Value: The goal here is to find out a high-quality brand that is at a low P/E ratio as in this strategy the focus of buying the stocks is to get stocks that seem cheap compared to their actual business worth.
- Quality: Here the strategy for an investor is to opt for the stock of companies that have strong management, well managed working with stable earnings, low debts, and strong financials.
- Low Volatility: This strategy focuses on stocks with smoother price moves as this helps in reducing overall portfolio risk and standard deviation.
- Momentum: This strategy helps in investing in such stocks that have a positive upward trend with a hope that the trend will continue to move upwards.
- Dividend Yield: The strategy focuses on regular dividend yielding, which becomes a popular choice for investors looking to earn a regular income from their investments.
- Equal Weight: In this strategy every stock gets the equal share rather than giving preference to the bigger companies only, equal-weight share improves diversification and reduces the risk of dependence only on big companies and their performance.
Know More: Calculate returns on ETF investments.
Benefits of Smart Beta ETFs
- Risk-Adjusted Returns: With smart beta, it is not just about higher returns, but fulfilling better returns for the risk taken. These ETFs focus on factors that have performed well historically in an attempt to outperform traditional market cap funds over a long time.
- Enhanced Diversification: As we explained, a Nifty 50 ETF is often overweighted to the top 5 or 10 stocks. Smart beta strategies that focus on equal weighting invest more evenly across a greater number of stocks. This diversification helps to mitigate the risk of one or two large stocks underperforming and the impact of those stocks dragging down the whole portfolio.
- Rule-Based Approach: These rules, or rather strategies, have distinct advantages which are often overlooked. Pre-defined rules help to overcome emotional biases and behavioral mistakes which can negatively impact the portfolio. Smart beta ETFs have rules which are set so that there is no room for emotional decision making. For instance, a value ETF is programmed to sell stocks which are deemed expensive and purchase stocks which it considers to be cheap, is an example of forcing you to operate in a buy low, sell high mentality.
- Cost-Effectiveness: Though Smart Beta ETFs can be a little expensive than most of the passive ETFs, they are generally much cheaper than actively managed mutual funds pursuing similar factor strategies.
Read Also: Small-Cap ETFs to Invest in India
Risks of Smart Beta ETFs
Of course, no investment is without risk. It’s important to have a balanced view and understand the potential downsides.
- Factors Can Underperform: Out of all the risks, this is the most important to understand. Every factor has losing streaks. There can also be long periods of years when a value strategy lags behind the market, whereas a momentum strategy fails during a sudden market crash.
- Limitation of Backtesting: A lot of smart beta strategies “work” in “back-tests” or simulation-based on past data strategy. But as every investor knows, past performance is no guarantee of future results. A strategy that worked every decade doesn’t seem plausible to work for the next decade.
- Higher Costs and Complexity: Smart Beta ETFs, owing to their complex nature in both design and management, charge a conditionally higher expense ratio as compared to the plain and simple INDEX ETFs. Although the difference may be small, it is still evident.
- Lower Liquidity: Out of the newer or more niche smart beta ETFs in India, some might have comparatively lower liquidity, or volume of participants to buy and sell parts of the ETF on a daily basis. It may not be a major concern for most small investors, but it may pose a challenge for those looking to trade a considerably large volume of the ETF in a short time.
- The Psychological Challenge: Smart beta ETFs are designed to perform differently from the main market. This difference is called “tracking error.” While this is intentional, it can be mentally tough. Imagine the Nifty 50 is up 20% in a year, but your low volatility ETF is up only 8%. It’s easy to feel like you’re missing out and be tempted to sell at the wrong time. Sticking with the strategy requires conviction.
Why Do Investors Choose Smart Beta ETFs?
Smart beta ETFs are selected by the investors because they look for more strategic investments rather than just buying randomly from the market and also investors don’t want to pay the high fees or rely on the judgment of an active fund manager. They offer a middle ground that is rules-based, transparent, and cost-effective.
It is for investors who want to buy quality companies stock or undervalued stocks for the long-term as Smart Beta ETF allows the investors to make the investments simpler and in a disciplined way.
Read Also: Types of ETFs in India: Find the Best for Your Investment
Conclusion
Smart beta ETFs are not just simple ETFs but they are new powerful and innovative tools that are designed for modern investors like you. Though you need to keep in mind that they do not provide guaranteed high returns but they provide a strategic investment plan to build your portfolio.
The strategy to invest in Smart beta ETFs depends upon your investment goals, as understanding the right strategy with patience can help you excel your financial goal.
Frequently Asked Questions (FAQs)
Do Smart beta ETFs give guaranteed returns?
No, the returns in smart beta ETFs are not guaranteed but they are designed with a potential to give better risk-adjusted returns in the long run, but the chances of their performance is greater than Nifty 50 ETFs in the long term.
Are smart beta ETFs actively managed?
No, smart beta ETFs are not actively managed. They are best described as a hybrid. The strategy behind Smart Beta Indices is active (e.g., choosing focus, value, etc.), but the fund itself is managed passively. A human fund manager is not making daily buy or sell decisions.
Difference between a smart beta ETF and a normal Nifty 50 ETF?
In a Nifty 50 ETF the focus is more on the bigger companies based on the market capitalization. On the other hand, smart beta ETF deals differently by giving weightage to companies based on factors like low price, financial health or low volatile company.
Are smart beta ETFs expensive?
Smart beta EFTs are expensive compared to the traditional index ETFs, but they are less expensive than actively managed mutual funds.
Are smart beta funds suitable for beginners?
They can be, but it’s important for a beginner to first understand the basic concept of an index ETF. If you are willing to learn about the specific factor (like value or quality) and understand that the fund will behave differently from the main market, it can be a good addition to your portfolio.
