Why smart beta funds follow rules instead of market size

Most index funds hold shares in proportion to their market value. Smart beta funds use different rules. This page explains what smart beta means, the main types and what to check before you consider one.

Quick answer

Smart beta is an approach where an index fund or ETF follows an index that selects or weights shares using rules other than market capitalisation. These rules may be based on factors like value, momentum, quality or low volatility, or on simple methods like equal weighting. It mixes the low cost and transparency of passive funds with a tilt towards chosen traits.

Key takeaways

• It uses rules other than market value to weight shares.
• It is a practical way to apply factor investing.
• Equal weight, low volatility and momentum are common types.
• Such funds in India track NSE and BSE factor indices.
• They can lag regular index funds for long periods.

What does smart beta mean?

In a normal index like the Nifty 50, larger companies get a larger weight. This is called market capitalisation weighting. This approach changes this rule. It picks or weights shares by other traits, while still following a fixed, published index.

'Beta' here refers to market returns. 'Smart' is a marketing word for using a different rule, not a sign of better results. It is still a passive approach, because the fund follows an index rather than a manager's choices.

Common types of rules-based weighting

Some indices combine two or more factors, such as value and quality, in one rule set. Each method changes the mix of shares and sectors compared with a normal index.

Smart beta in India

NSE Indices publishes many such indices, for example the Nifty 50 Equal Weight, Nifty100 Low Volatility 30 and Nifty Alpha 50. Several fund houses offer index funds and ETFs based on them.

SEBI's rules for mutual funds treat these as index funds or ETFs, so they must track their index closely. Investors can check tracking error and expense ratio to see how well a fund follows its index.

What should you check?

Read the index method to understand how shares are picked and how often the list changes. Frequent changes can raise costs. Check the expense ratio, which is usually higher than a plain index fund but lower than many active funds.

Look at how the fund behaved in different market phases, not just the recent past. Such a fund can lag the regular index for years if its factor is out of favour. Past performance is not indicative of future results.

The key point to remember

This approach follows clear rules that differ from market value weighting. It can be a low-cost way to tilt towards a trait, but the word 'smart' does not mean it will do better than the market.

The securities and commodities named here are mentioned only to explain how the market works and are not a recommendation to buy, sell or hold them.

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