Understanding smart beta funds and how they can boost index returns

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passive funds, we have a variation of beta, called Smart Beta. Exchange-traded funds (ETFs) or index funds replicate an index and don’t aim to generate excess returns. However, smart beta involves indices designed to potentially outperform the market.

In general, investors refer to indices like Sensex, Nifty, midcap, and smallcap indices as markets. These indices have two things in common: - They would be diversified across sectors and themes. For example, the indices would consist of stocks from financial services, IT, oil & gas, and others.

The weights of stocks would be based on their market capitalization, which means that large stocks with higher market capitalization would have a higher weight in the index, whereas another stock with lower market capitalization would have a lower weight. Also Read: Dear investor, you don’t have to run a mutual fund on mutual funds In the Nifty 50 Index, the top stock has a weight of 11%, whereas the last stock has a weight of less than 0.5%. Similar phenomena occur in midcap and smallcap indices.

Any variation on these indices that would work differently and could potentially generate better returns from time to time may be considered ‘smart beta’ strategies. The NSE and BSE aptly classify such indices as ‘strategy’ indices. These indices apply specific rules to broad market indices like Sensex, Nifty Midcap, Nifty 500, etc., which could potentially outperform the parent indices.

Passive funds that replicate or track strategy or smart beta indices are called smart beta funds. Several such strategy indices are available in the Indian markets. Value, growth, quality, momentum, dividend opportunities, alpha, low volatility, and equal weight, are some of the popular strategy indices.