Smart Beta Index Funds: The Next Frontier of Passive Investing in India

• Smart beta funds combines passive index tracking with “factor-based” stock selection.

• They start with a benchmark index and then select or weight stocks based on the chosen factors , such as Value, Momentum, Quality, Volatility, Size (market cap), and Dividend.

• Smart beta index funds can focus on a single factor or combine multiple factors to build a diversified portfolio.

There are broadly two paths to mutual fund investing: Active and Passive. You either rely on a fund manager’s ability and pay them higher fees or invest in an index mutual fund at a relatively lower cost. 

But what if you need both? “Smart Beta Index Funds” combine both active and passive investment approaches. Read this article to learn what Smart beta index funds are, how they work, and differ from traditional index funds.

Smart beta index funds are a mix of active and passive mutual funds. They do NOT:

• Only follow a market-cap index (like a normal passive fund)  or 

• Only perform discretionary stock picking (like an active fund)

Instead, in a smart-beta strategy, the fund first starts with a broad index (for example, Nifty 100 or Nifty 200). From this universe, they may apply a pre-defined set of rules called “factors” to select and weight stocks. Note that each factor is a different method to judge companies. A fund may use one factor or combine several factors to build its portfolio from a larger index.

After applying the factor(s), only a smaller group of stocks is selected, and the Smart beta index fund is built from them. For more clarity, let’s study the six main factors used in smart-beta strategies:

“Smart beta” index funds and “traditional” index funds both follow a rules-based investing approach, but they differ in how stocks are selected and weighted. 

• Traditional index funds only replicate/ track their benchmark index, whereas
• Smart beta index funds use specific investment “factors” to construct their portfolios.

For more clarity, let’s understand the comparison in detail:

So now you know what smart beta cap index funds are, how they work, and what factors they consider to select stocks. If we were to revise, smart beta funds are a blend of active and passive index investing. They start with a benchmark index and select stocks from the index constituents based on specific factors, such as:
 

• Value: Select undervalued stocks based on valuation ratios like P/E and P/B

• Momentum: Selects stocks that have shown strong recent price performance

• Quality: Selects financially strong companies with stable earnings and low debt

• Volatility: Selects stocks with lower price fluctuations

• Size: Classifies and selects stocks based on market capitalisation

• Dividend: Focuses on stocks with stable dividend income and growth potential
   

Note that such funds may perform better than traditional index funds due to “factor-based” stock selection. However, if the chosen factors do not align with prevailing market conditions, the NAV of these funds may decline more than traditional index funds. Thus, investors may assess their risk appetite and investment objectives before investing. 

1. What are some examples of Smart beta index funds?

   Some examples you may study are:

   • A Nifty Alpha 50 Index fund selects 50 stocks from the Nifty 200 Index universe based on their “alpha score” (which measures how much a stock has outperformed its benchmark after considering risk).

   • A Nifty 200 Momentum 30 fund assesses 200 companies from the Nifty 200 universe and may select 30 stocks based on recent price trends. 

   • A Nifty 100 Low Volatility 30 fund starts by evaluating 100 companies from the Nifty 100 universe and picks 30 stocks based on the lowest Standard deviations.
     
     

2. Can smart beta funds combine multiple factors?

   Yes, smart beta funds may:

   • Use a “single” factor (such as momentum or low volatility) or

   • Combine “multiple” factors (like quality, value, and momentum in one portfolio)

     As per general market understanding, fund managers combine different factors with an aim to create a more balanced portfolio so that dependence on a single factor is reduced across different market conditions.
     
     

3. Should beginners invest in smart beta index funds?

   Investors may first evaluate how the selected factors in a smart beta index fund work, as the fund’s performance depends largely on:

   • Factor selection and

   • Prevailing market cycles

     As per general understanding, several beginners first start with broad index funds and later add smart beta exposure gradually.