What Are Smart Beta ETFs?

A Smart Beta ETF is a specific type of exchange-traded fund that combines elements of both passive and active investing models. These funds adhere to a rule-based approach for choosing investments to be included in their portfolios. Each security or stock in the fund is assigned a specific weighting based on the strategy selected from at the outset. Let us dive deeper into them below.

What Is a Smart Beta ETF?

Smart Beta ETFs are unique versions of regular ETFs, modifying investments in the portfolio depending on specific financial metrics. The fund portfolio composition is determined by the rules established at the time of the fund's launch. Every security or stock in the fund receives a weighting depending on the strategy that is adopted. 

Hence, it is a mixture of both passive and active investment models. These ETFs choose companies based on factors like volatility, dividend growth, total earnings, and expectations, to name a few. They track an index and account for multiple factors to choose securities from the index.

For example, an equal-weight Nifty 50 fund will invest in all 50 Nifty companies, while giving each one of them equal weights. However, the smart beta fund will screen these stocks based on earnings stability and assign more weightage to those entities with better fundamentals. 

It is also worth noting that ETFs are different from mutual funds, even though both contain baskets of individual securities like bonds or stocks. The latter has orders executed once each day, and all investors get the same prices at the end of the day. The former trade in stocks is conducted on stock exchanges. They thus witness price fluctuations on each trading day. 

Weighting Strategies

Smart beta ETFs have several weighting strategies, depending on various factors. They can choose securities based on aspects like total earnings, dividend growth, expectations of volatility, market capitalisation, and more. Some of these strategies include: 

• Equal weightage - This strategy weighs all securities equally, depending on their market capitalisation. It does not weight them based on financial performance or the stock prices. 
• Fundamental weightings- Some smart beta ETFs follow a strategy where the selection and weightings of companies depend on financial metrics and fundamental aspects (revenue, total earnings, profits).
• Low-volatility weightings - This approach focuses on securities that have historically exhibited lower volatility. The price fluctuations in securities are measured as volatility, and the higher this quotient, the higher the overall risks. 
• Factor-based weightings- It is a strategy that involves weighting securities based on specific factors separated across levels. These may include underpriced valuations, smaller companies, balance sheet components, etc. 

Types of Smart Beta ETFs

Here is a closer look at some of the types of smart beta ETFs. 

• Factor Identification - These are ETFs that select a factor-based strategy for their operation. It may be value, quality, or momentum. 
• Index Construction - This involves creating a custom index that focuses on stocks with low price-to-earnings or price-to-book ratios, as well as stable stocks. 
• Portfolio Replication - This ETF aims to replicate the performance of any custom-built index. This is done by holding the underlying securities in specific proportions. 
• Rebalancing - The index and the ETF portfolio are rebalanced periodically (either semi-annually or quarterly) based on predefined rules. This helps maintain the necessary factor exposure amidst changing market conditions. 

It is advisable to examine the various kinds of ETFs available across sectors before finalising investments. 

Passive and Active Management

ETFs differ from mutual funds and other investments in their combination of active and passive management strategies. The active investment model usually involves fund managers deciding on buying and selling securities. They aim to outperform any benchmark or index while making profits simultaneously.

Actively managed funds are those where securities are purchased or sold as required, based on multiple financial metrics like earnings and financial ratios. On the other hand, passive funds track indexes like the S&P 500, where securities are traded in proportion to the market share in that very index. 

These funds do not need investment managers to select stocks and have lower fees as a result. In this context, smart beta ETFs combine the features of passive and active management effectively. They track the index in a manner similar to a passive fund, while also considering multiple strategies to select stocks from the index, much like an active fund. These stocks are chosen based on a weighting strategy.  

Benefits of Smart Beta ETFs

Smart beta ETFs come with multiple benefits for investors. Some of them include: 

• Diversification - You can rely on these ETFs to efficiently diversify your portfolio. They help you choose stocks based on multiple factors and sectors. 
• Transparency - Rule-based ETF approaches make it easy for you to understand how the portfolio is built. You know precisely what you’re getting into. 
• Targeted Exposure - You can choose from a wide range of options that follow different smart beta indices. This will help you find something that matches your investment objectives. 
• Low Expense Ratios - These funds typically have lower expense ratios compared to actively managed funds. 

Choosing the right smart beta ETFs will help you potentially increase your investment returns, maximise dividends, and improve your chances of aligning outcomes with your preferences (risks, costs, etc.). 

Risks of Smart Beta ETFs

Some risks associated with smart beta ETFs include the following: 

• Trading volumes may be comparatively lower in these ETFs, since these are relatively newer methods of investing. 
• It may lead to lower liquidity and hinder your ability to exit easily from your positions. 
• These ETFs buy securities from indexes that will be included in their portfolios. Trading costs are naturally higher in this scenario, even though the fees may be lower than those of actively invested funds. 
• With multiple variables to consider while investing in these ETFs, trading them may be more challenging than trading conventional indexes. 
• Smart beta funds may underperform passive indexes because they are continuously traded, unlike a buy-and-hold approach. 

Example of a Smart Beta Fund

There are various kinds of smart beta funds that you will find in the market. For example, the Grow Nifty India Internet ETF tracks the Nifty India Internet Index. It is tailored to offer exposure to the internet sector in India by mirroring the performance of the companies on the index. It aims to replicate the index’s composition rather than actively selecting stocks. 

Some other examples include the Nippon India ETF NV20, which tracks the Nifty 50 Value 20 Index and many others. A global example would be the Vanguard Dividend Appreciation Index Fund, which chooses companies from the S&P U.S. Dividend Growers Index. Some of these entities include Microsoft Corp, Apple Inc, Visa Inc, JP Morgan Chase & Co, and Procter & Gamble. 

What Is the Difference Between a Market-Cap Weighted ETF and a Smart Beta ETF?

It should be noted that there are key differences between smart beta ETFs and market-cap weighted ETFs. Most major indexes are market-cap weighted, with the highest weight allocated for the biggest companies. Smart beta, on the other hand, uses strategies like fundamental or equal weighting, low volatility and minimum variance. 

These funds differ from market-cap weighted indexes in that they adhere to predefined rules for choosing and weighing securities. They give equal weight to all stocks or rank them based on several factors. 

Why Do Investors Choose Smart Beta ETFs?

Investors usually choose smart beta ETFs to diversify their portfolios and optimise investment returns through combining passive and active management strategies. 

Systematic and factor-based exposure helps lower risks and volatility, while there is complete transparency into how and why stocks are weighted. They are also more affordable than actively managed funds while being less vulnerable to emotional biases and decision-making. 

Smart Beta vs Thematic/Commodity ETFs

Thematic ETFs focus more on specific trends, industries, themes like technology or sustainability, or even developing markets. Commodity ETFs concentrate on specific commodities traded in the markets. For example, gold ETFs often track changes in gold prices and make investments in the commodity or related instruments. 

Taxation on Smart Beta ETFs

Choosing a tax-efficient ETF is a must. Here are some key points worth knowing in this regard: 

• Dividends from ETFs in India are treated in the same way as dividends received from other equity investments. 
• They are taxable at the applicable slab rate on your income. Hence, the income will be added to your total income and taxed likewise. 
• Capital gains from ETFs are dependent on the type of ETF and the holding period. STCG is as per the income tax slab for some ETFs, while it is 20% for equity. At the same time, LTCG is payable at 12.5% with specific caveats, while for debt ETFs, it is based on the income tax slab. 

Conclusion

Smart beta ETFs are good investments if you want to diversify your portfolio efficiently, while benefiting from the unique combination of active and passive investment methods. They can help you build a portfolio comprising securities from multiple sectors and of various types. However, it is essential to do your research thoroughly before investing.