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What are smart-beta funds and their types?

Smart beta funds provide you with the best of active and passive funds. In this article, we will understand what are smart beta funds and their types.
What are smart beta funds and their types?

Smart beta funds provide you with the best of active and passive funds

Active funds have the potential to outperform the benchmark index and give superior returns. However, their expense ratio is on the higher side. On the other hand, passive funds have a lower expense ratio than active funds. However, they mirror the benchmark index and deliver similar returns. They cannot outperform the benchmark index. This is where smart beta funds come into the picture. They have the potential to outperform the benchmark index and deliver superior returns but with a lower expense ratio. So, smart beta funds provide you with the best of active and passive funds. In this article, we will understand what are smart beta funds and their types.

What is a smart beta index?

To understand the concept of a smart beta index, let us begin by understanding what beta is. In very simple terms, beta is the risk involved in an investment. For example, let us assume that the Nifty 50 Index has a beta of 1 and Reliance Industries Limited (RIL) has a beta of 2. It means the investment in RIL carries double the amount of risk as compared to investing in the Nifty 50 Index. Hence, an investor will expect RIL investment to earn double the return compared to the Nifty 50 Index to compensate for the higher risk (double of Nifty 50). In this case:

  1. If the Nifty 50 Index moves up by 10%, RIL will be expected to go up by 20%
  2. If the Nifty 50 Index moves down by 10%, RIL will be expected to fall by 20%

So, the returns expected from an investment will be proportional to the risk (beta) involved. However, what if the risk (beta) can be reduced, but the return expectation can be kept the same? That is what smart beta indices are expected to do. For an expected rate of return, a smart beta index can reduce the proportionate risk (beta). A smart beta fund aims to reduce risk and generate better returns than a broader market capitalisation index such as Nifty 50 at a lower cost.

How are smart beta indices constructed?

A smart beta index, also known as a strategy index, straddles between active and passive investing. A smart beta index is constructed from a traditional market capitalisation index, based on equal weight investing style or certain factors such as momentum, alpha, volatility, quality, etc. A smart beta index has the potential to beat various broad market indices such as Nifty 50, Nifty Midcap 150, Nifty Smallcap 250, etc. indices that are based on market capitalisation.

  1. Equal weight: A smart beta index may include all the constituents of a traditional market capitalisation index, but the investing pattern may be different. For example, the Nifty 50 Equal Weight Index is a smart beta index that has all the constituents of the Nifty 50 Index (broad market index). But, while the traditional Nifty 50 Index is based on market capitalisation, the Nifty 50 Equal Weight Index assigns equal weight to all the Nifty 50 constituents. Although the Nifty 50 Equal Weight Index is a passive index, it has the potential to beat the benchmark Nifty 50 Index. Another example of an equal weight smart beta index is the Nifty 100 Equal Weight Index.
  2. Factor based: A smart beta index may include some constituents of a traditional market capitalisation index. These constituents are selected based on certain factors such as momentum, alpha, volatility, quality, etc. For example, the Nifty 200 Momentum 30 Index has 30 constituents from the Nifty 200 Index. The 30 stocks are selected based on the high Normalised Momentum Score.

What are the different types of smart beta indices?

As of December 2021, the NSE has launched 28 strategy-based indices or smart beta indices. Based on these indices, mutual fund houses have launched 18 smart beta mutual fund schemes.

Some of the smart beta indices or strategy based indices launched by the NSE include:

  1. Nifty 200 Momentum 30 Index

The Nifty 200 Momentum 30 Index aims to track the performance of 30 high momentum stocks from the Nifty 200 Index. The 30 stocks are selected across large and mid-cap stocks. The Momentum Score for each stock is based on recent 6-month and 12-month price returns, adjusted for volatility. The index is rebalanced semi-annually in June and December. Since its inception, the index has given a splendid price return of 19.66% CAGR (2005).

The above chart shows how Rs. 1,000 invested in the Nifty 200 Momentum 30 Index in 2005 would be worth Rs. 20,000 as of 30th November 2021.

  1. Nifty Midcap 150 Quality 50

The Nifty Midcap 150 Quality 50 index includes the top 50 companies from the Nifty Midcap 150 Index. The companies are selected based on their 'quality' scores. The quality score for each company is determined based on return on equity, financial leverage (except for financial services companies), and earning per share (EPS) growth variability of each stock analysed during the previous five financial years.

The index is rebalanced semi-annually. Since its inception, the index has given an excellent price return of 18.70% CAGR (2005).

The above chart shows how Rs. 1,000 invested in the Nifty Midcap 150 Quality 50 Index in 2005 would be worth Rs. 17,500 as of 30th November 2021.

  1. Nifty 100 Alpha 30

The Nifty 100 Alpha 30 Index consists of 30 companies from the NIFTY 100 Index, selected based on their alpha scores. The alpha score for each company is determined based on Jensen's alpha computed using one-year trailing prices. The index is rebalanced quarterly. Since its inception, the index has given an excellent price return of 16.34% CAGR (2005).

  1. Nifty 100 Low Volatility 30

The Nifty 100 Low Volatility 30 Index aims to measure the performance of the low volatile securities in the large market capitalisation segment. The securities are selected from the Nifty 100 Index. The selection of securities and their weights in Nifty 100 Low Volatility 30 are based on volatility. The index is rebalanced quarterly. Since its inception, the index has given an excellent price return of 16.59% CAGR (2005).

The above chart shows how Rs. 1,000 invested in the Nifty 100 Low Volatility 30 Index in 2005 would be worth around Rs. 12,500 as of 30th November 2021.

How can investors invest in smart-beta funds?

AMCs offer various mutual fund index schemes or exchange-traded funds (ETFs) based on smart beta indices. Some of these include:

Smart beta indexETF/Index fund
Nifty 50 Equal Weight IndexIndex funds available from DSP, Aditya Birla, and HDFC AMC
Nifty 100 Equal Weight IndexIndex funds available from Principal AMC and Sundaram AMC
Nifty 100 Low Volatility 30 IndexETF and Fund of Fund (FoF) available from ICICI AMC
Nifty 200 Momentum 30 IndexIndex fund available from UTI AMC
Nifty Alpha Low Volatility 30 IndexETF available from ICICI AMC
Nifty 100 Quality 30 IndexETF available from Edelweiss and SBI AMC
Nifty 50 Value 20 IndexIndex fund available from Nippon AMC, ETF available from Nippon, Kotak, ICICI

(Source: https://fpa.edu.in/blog/smart-beta-indices--neither-entirely-active-nor-entirely-passive)

AMCs are expected to launch more index funds and ETFs based on various smart beta indices in the future. An investor may consider their risk profile and choose the fund for investment accordingly.

Investing in smart beta funds with Glide Invest App

The above section saw how an investor can invest in various smart beta funds. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate smart beta funds and other mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals

With Glide Invest, you will get guidance for:

  1. A personalised risk profile assessment
  2. Identifying your financial goals
  3. Appropriate asset allocation
  4. Making a financial plan for each goal
  5. Automating the financial plan
  6. Review and analysis of your financial plan 
  7. Hand holding you till your financial goals are achieved

To start investing towards your financial goals, download the Glide Invest App from Google Play Store or Apple App Store and get started.

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