Smart beta funds: Key benefits, risks and investment strategy

Synopsis

Smart beta funds represent a hybrid approach, merging the advantages of passive and active investing to enhance returns. Implementing specific guidelines for stock selection and weighting, they provide cost-effective solutions with greater transparency. While there may be times when smart beta trails behind traditional indices, they can serve as a valuable addition to diversify and strengthen investors' portfolios.

As investors look beyond traditional index funds, smart beta strategies are gaining traction. By combining passive investing with factor-based stock selection, these funds seek to deliver superior risk-adjusted returns while retaining the transparency and lower costs associated with index investing.

WHAT ARE SMART BETA FUNDS? HOW DO THEY WORK?

Smart beta funds combine elements of both active and passive investing strategies. They aim to outperform the market or achieve specific investment objectives without relying solely on traditional methods. They use predefined rules or strategies to select and weight stocks, rather than simply mirroring an existing market index like most passive funds.

Popular smart beta strategies include Nifty 200 Momentum 30 Index Funds, Nifty 100 Low Volatility 30 Index Funds, and Nifty 200 Quality 30 Index Funds.

Read more: Best aggressive hybrid mutual funds to invest in September 2026

WHAT ARE THE ADVANTAGES OF SMART BETA FUNDS?

Smart beta funds combine the lowcost, rule-based approach of passive investing to capture specific investment factors such as value, quality, momentum and low volatility. Unlike actively managed funds, smart beta funds generally follow predefined rules for selecting and weighting stocks. As a result, investment decisions are less dependent on the personal views of a fund manager, and the funds typically have lower costs than actively managed mutual funds.

These schemes provide exposure to companies and investment characteristics that differ from a conventional market-capitalisation index. For example, a quality-focused fund may have a different portfolio composition from the Nifty 50. The methodology for stock selection, weighting and rebalancing is generally disclosed in advance, bringing greater transparency. Investors can understand which stocks qualify for inclusion, how stocks are weighted, when the portfolio is rebalanced and which factor the strategy targets.

IS THERE ANY DISADVANTAGE TO A SMART BETA STRATEGY?

Smart beta strategies can underperform traditional indices for extended periods. For example, momentum may struggle during sharp market reversals, while value strategies may remain out of favour for years.

Although a smart beta fund may hold many stocks, its factor-based rules can result in high exposure to particular sectors, concentration in certain types of companies and greater exposure to a specific group of stocks. Some smart beta strategies, particularly momentum strategies, may require frequent rebalancing, which can lead to higher transaction costs, greater portfolio turnover and potentially higher tax implications for investors, depending on the fund structure and applicable tax rules.

WHAT COULD INVESTORS DO?

Smart beta funds may be suitable for investors who want to diversify beyond traditional indices and gain exposure to factor-based investing, have a long investment horizon of at least five to seven years, understand factor cycles, and prefer a rules-based approach to investing.

Wealth managers believe investors should not allocate 100% of their portfolio to such strategies. Instead, they can use smart beta funds to complement their existing portfolio of active and passive investments. For example, investors may use a quality or low-volatility fund alongside a broad-market index fund or an active flexi-cap fund.