Smart Beta Funds: The smarter version of ETF

An investor’s worst enemy is not the stock market, but her/his own emotions. This remains the sordid truth. Over the years, several investment strategies have been developed that actually tackle this fundamental problem – emotion.

Investing through a SIP route works automatically and so investors don’t need to make any decisions about investing each month. Passive investment products, such as index funds and exchange-traded funds (ETFs), have combined emotion-less investing with lower costs to offer an attractive proposition.

Over the years as ETF evolved, a new class of ETFs emerged known as Smart Beta ETF. A smart beta ETF is considered to be the intelligent version of passive investment products. They improve upon the basic idea of an ETF or an index fund and in doing so; they enhance returns by taking the middle-ground of passive and active investing paradigms.

Move over plain-vanilla ETF

The aim of a passive fund is to mirror the movement of an underlying index by holding the securities in exactly the same manner. An index fund is an example of a passive product. An ETF is essentially an index fund but it gives the added flexibility of being traded on an exchange like a stock. An index fund cannot be traded on the stock exchange, but an ETF can and so it gives the freedom to investors to enter or exit during market hours.

Distinct design

Smart Beta funds are distinct from the other passive products. The use of rules, filters and parameters separate them from traditional ETF offerings. Many investors who are savvy when it comes to investment matters may find the plain vanilla index fund or an ETF to be boring. For such investors, smart beta is the option to consider.

In a smart beta index, using rule-based investment filters, securities are chosen based on their ability to meet certain set criteria. Most often data-centric parameters like low volatility (lower variation in price), value (stocks relatively cheaper), quality (consistent growth irrespective of the business cycle), or momentum (following the trend) are the factors used in creating a smart beta index. Alternatively, some smart beta funds may track the same stocks as traditional benchmark indices, but offer different exposures, or weight, to the underlying stocks. All of these are in an attempt to boost risk-adjusted returns.

While new in India, smart beta as a concept is well entrenched and accepted globally. Owing to the tweaking done to say benchmark indices, such strategies tend to out-perform a typical index.

Smart Beta funds can even be considered a middle ground between the active and passive style of investing. The portfolio of a Smart Beta fund typically is not a crowded one. Stocks from a selected universe that meets a certain criterion are the ones that become a part of the smart beta index. One of the main reasons why Smart Beta funds strike an immediate chord with investors is the hand-picked nature of portfolios. Thus far, these categories of funds have managed to deliver superior returns. Even on the cost of the fund aspect, smart-beta funds emerge to be cheaper.

In a nutshell, smart-beta funds are transparent in design and rule-based in nature when it comes to stock selection. Over the years, such strategies have demonstrated their ability to beat the markets with comparatively lower risk and reduced cost.

by Nitin Kabadi, Head ETF Business, ICICI Prudential AMC