Smart-beta ETFs: Everything you need to Know

In the last blog, we discussed different types of ETFs available in India and if you recall, one of the categories of ETFs was smart beta ETFs.

So, in this blog, we will discuss more regarding smart beta ETFs. The idea is to help you understand how they work.

Smart beta strategies have become popular in the last 10 years and ETFs are the best vehicle to take exposure to smart beta strategies. Therefore, any discussion on ETFs is incomplete without dedicating some space to smart beta ETFs.

Investing Styles

We know there are two types of investing – passive investing and active investing.

Active managers use their discretion to pick securities and try to outperform the benchmark. Passive investing, on the other hand, is all about replicating the benchmark.

Smart beta strategies lie in between. Smart Beta strategies use a transparent rule-based portfolio construction mechanism (hence not passive). But the manager does not have the discretion to pick securities based on his/her views (hence not active). The strategy is codified and hence follows the defined rules for portfolio construction.

Think of smart beta as follows – over years, researchers and active managers have studied various ways to deliver strong returns. They have uncovered empirical evidence of what works and what doesn’t. These insights were then converted into a set of automatic rules that can be executed without human intervention. That’s a smart beta for you.

The diagram below provides a visual representation of the style spectrum.

Since smart-beta strategies can be codified and automated, we can create indices to track these strategies. And smart beta ETFs track those indices.

Different Types of Smart Beta

The automation rules of a smart beta strategy are basically:

• Screen the list of securities to invest (long and short), based on some factor/signal
• Calculates the amount to invest in each security
• Keep doing this every month or every quarter (or any predefined interval)

The first step, where securities are screened based on a certain factor/signal, gives rise to different flavours of smart beta strategies.

Suppose a strategy picks 20 stocks from the Nifty 50 index that have the lowest PE ratio and then weighs them in inverse proportion to their PE ratio (lower PE stock gets more weight). This is a value strategy looking to exploit the value premium.

There are other strategies that look to exploit the momentum premium or the quality premium. Then there are multi-factor strategies that consider multiple factors in portfolio construction.

To make it easier for investors to follow these strategies, all of them can be converted into indices that can be tracked by exchange-traded funds (ETFs).

The table below shows the availability of smart beta ETFs in India.

Why does Smart-beta Work?

Not all smart beta strategies work (or will work in the future). To understand why smart beta works, we have to understand the concept of systematic risk factors.

Systematic risk factors reward investors for taking exposure to them. They are called systematic because the risk premium (reward) associated with them has a fundamental or behavioural explanation and will not go away due to competition.

Smart beta strategies are based on systematic risk factors. While smart beta strategies can be constructed using multiple factors, it is important that the factors are systematic. In other words, if the factors are not systematic, the beta isn’t smart.

A factor can be deemed systematic if:

• It has delivered a positive (and statistically significant) risk premium across time periods and across markets.
• The underlying risk premium can be explained by some fundamental or behavioural logic.
• There exists sufficient research to back both the points.

The list of factors is large, and not all of them are systematic. However, there has been enough evidence to show that value, momentum, quality, and low volatility factors are systematic in nature. Perhaps this is the reason that these factors dominate the smart beta ETF space.

FAQs

How are Smart Beta ETFs different from traditional ETFs?

A Smart Beta ETF constructs its underlying index differently from a traditional ETF. Traditional ETFs track market capitalization-weighted indices, while Smart Beta ETFs track indices based on specific factors or combinations of factors.

Are Smart Beta ETFs available in India?

Yes, Smart Beta ETFs are available in India. Several AMCs offer Smart Beta ETFs that track different factors such as low volatility, value, growth, momentum, and quality.