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Is it a Smart Investment Strategy to Invest in Smart-Beta Funds?

21 June 2022

Investor always hopes the momentum of their investment returns will shoot up. They are always looking for more efficient and lucrative investment options. To keep pace with rising investor expectations, fund managers and fund houses keep coming up with innovative investment schemes.

Earlier investors only had the option to choose between the actively and passively managed investment approaches. However, the emergence of smart-beta funds in 2003 broke this duopoly. 

The name Smart-beta funds are more than just a smart catchphrase to attract investors. Smart-beta funds assimilate the goods of both active and passive management strategies, and the stock selection process considers several other factors than just market cap. 

What are Smart Beta Funds? 

Smart-beta funds track the benchmark index the same way as traditional funds. However, the difference kicks in when weighing securities. Actively and passively managed funds strategies use capitalization-weighted methods, where individual stocks are assigned weights in proportion to their weightage in the benchmark index. Smart-beta funds bank upon multiple factors to select and weight stocks. 

With a traditional fund, it is obvious that a stock with a higher market cap will be weighed higher; there's no such case with smart-beta funds. 

For example, the stock of Borosil Renewables Ltd, a renewable resources company, has performed exceptionally well in the recent past. But it wouldn't be considered by funds that use the market capitalization method. This is because the stock doesn't carry a high market cap. However, a smart beta fund would consider the stock if it stands tall on the different selection factors. 

The smart-beta strategy

The driving force is to surpass the returns generated by traditional investment strategies smartly. To achieve this, smart-beta funds deploy multiple factors ranging from momentum, value, volatility, dividend yield size, low risk, and growth to select their portfolio of stocks. Since this approach uses multiple factors, it is also called factor-investing

It is important here to realize that there is no hard-fast rule to use and interpret the different factors; all these factors are non-standardized. 

Different fund managers might draw different conclusions from the same factor. It's also unnecessary to base the selection and allocation of stocks on a single factor, and multiple factors can govern the process. 

For instance, BHEL is a high dividend paying stock and a value stock was given the affordable valuation at which it trades. 

Factors Considered

While there can be several factors to assess the performance of stocks, the following are the most commonly used factors:

  1. Dividend yield: The objective is to find out the dividend distribution rate and periodicity of the stocks. It is also worthwhile observing if the dividend payments follow a rising trend or a declining trend, and the former will be given higher preference.
  2. Intrinsic value: Works on the governing principle of ‘Inexpensive stocks tend to outperform.’ Intrinsic value is the fundamental value of the stock calculated using metrics like Price To P/B Ratio, P/E Ratio, P/S Ratio, etc. If a stock is trading below its intrinsic value, it is worth investing, and if it is trading above its intrinsic value, other factors should be considered.
  3. Market cap: Assessing the percentage of the total market worth the stock accounts for. While market cap is just one factor in the smart beta approach, the entire traditional approach is based on it. 
  4. Quality: It is the potential of the stock to yield impressive returns. Return on equity(ROE), Return on capital employed(ROCE), Dividend growth, EBITDA margins, PAT, etc., are the metrics to evaluate the quality of stocks. 
  5. Momentum: Stocks that have performed well in the recent past are expected to continue to deliver good returns, and stocks that are sliding down will continue to slide down. 

Smart-beta funds in India

In India, it's still very early days for smart-beta funds, and there are only a handful of mutual funds and ETFs that follow the smart beta approach. However, given the widespread success of smart beta funds in developed countries, the approach is expected to flourish in India as well. 

The National Stock Exchange ( NSE) has already floated 28 such factor-based indices. Some of the popular indices are the NIFTY 100 Low Volatility 30 index, NIFTY 200 Quality 30, NIFTY 50 Value, etc. 

Following are some of the popular Smart-beta funds in India:

  • ICICI Prudential NIFTY Low Vol 30 ETF (2017)

Returns since inception: 56.89%

  • Kotak NV20 ETF (2015)

Returns since inception: 159.83%

  • Nippon India NIFTY 50 Value 20 Index Fund  (2021)

Returns since inception: 19.21%

  • UTI NIFTY 200 Momentum 30 Index Fund (2021)

Returns since inception: 19.59%

Should you invest in smart-beta funds? 

Though smart-beta funds have just started to roll out for Indian investors, they are already showing early signs of yielding better returns than funds based on market capitalization. They follow a transparent selection model and eliminate human emotions and subjectivity. 

However, smart beta strategies don't have enough historical data to back themselves and have not been tested much during market extremes. While these funds have a high potential for returns, investors are to tread cautiously even while diversifying a small portion of their investment amount into such funds. One can consider this only if there is an additional amount available after investing for your key financial goals. 

Disclaimer

The stocks mentioned in this article are not recommendations. Please conduct your own research and due diligence before investing. Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. NBT do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.
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