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Smart Beta Funds: the smarter version of ETFs

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An index fund cannot be traded on a stock exchange, but an ETF can and thus gives investors the freedom to enter or exit during market hours.

An investor’s worst enemy is not the stock market, but their own emotions. This remains the sordid truth. Over the years, several investment strategies have been developed to tackle this fundamental problem: emotion.

Investing through a SIP channel works automatically, so investors don’t need to make an investment decision every month. Passive investment products, such as index funds and exchange-traded funds (ETFs), have combined emotionless investing with lower costs to deliver an attractive proposition.

Over the years, as ETFs have evolved, a new class of ETF has emerged called the Smart Beta ETF. A smart beta ETF is considered the smart version of passive investment products. They improve the basic idea of ​​an ETF or an index fund and in doing so; they improve returns by taking the common ground of the passive and active investment paradigms.

Switch to plain vanilla ETF

The purpose of a passive fund is to mirror the movement of an underlying index by holding securities in exactly the same way. 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 a stock exchange, but an ETF can and thus gives investors the freedom to enter or exit during market hours.

Distinct design

Smart Beta funds are separate from other passive products. The use of rules, filters and parameters separates them from traditional ETF offerings. Many savvy investors may find the simple vanilla index fund or ETF boring. For these investors, smart beta is the option to consider.

In a smart beta index, using rule-based investment filters, stocks are chosen based on their ability to meet certain defined criteria. Most often, data-centric parameters such as low volatility (lower price change), value (relatively cheaper stocks), quality (constant growth regardless of the business cycle) or momentum (following the trend) are the factors used to create a smart beta. index. In addition, some smart beta funds may track the same stocks as traditional benchmarks, but offer different exposures or weightings to the underlying stocks. All of these are designed to drive risk-adjusted returns.

Although new to India, smart beta as a concept is well established and accepted around the world. Due to the adjustments made to benchmarks, these strategies tend to outperform a typical index.

Smart Beta funds can even be seen as a middle ground between active and passive investing style. The wallet of a Smart Beta fund is usually not crowded. The stocks in a selected universe that meet a certain criteria are those that are part of the smart beta index. One of the main reasons Smart Beta funds immediately hit investors is the hand-picked nature of the portfolios. So far, these fund categories have been successful in delivering superior returns. Even when it comes to the cost of the fund aspect, smart-beta funds seem to be cheaper.

In short, smart-beta funds are transparent in their design and based on security selection rules. Over the years, these strategies have demonstrated their ability to beat the markets with comparatively lower risk and reduced cost.

by Nitin Kabadi, Head of ETF Activities, ICICI Prudential AMC

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