If you are new to investing, you may have heard about smart beta funds and index funds. At first glance, they may seem similar because both follow a set of rules rather than relying on a fund manager to regularly pick stocks.
But there is an important difference in how those rules work.
Index funds simply aim to track a market index, while smart beta funds follow a specific strategy that gives more weight to stocks with certain characteristics, or “factors”.
So, is the extra layer of strategy worth it? Let’s break it down.
What Are Index Funds?
An index fund takes a straightforward approach. It aims to replicate a market index such as the Nifty 50 or the Sensex. It holds the same stocks, in almost the same proportion, as that index.
There is no attempt to identify which individual stock will perform best or avoid stocks that may perform poorly.
The idea is simple: rather than trying to beat the market, the fund aims to track it.
What Are Smart Beta Funds?
Smart beta funds work a bit differently. Instead of just following an index, they pick stocks based on certain traits. Smart beta funds, hence, try to mix the rule-based nature of passive investing with an attempt to focus on stocks that show these traits.
These traits are called factors, and common ones include value, quality, momentum, and low volatility.
Smart beta strategies can be offered as mutual funds as well as ETFs. You may already be familiar with the ETF format through products such as a Gold ETFs. Similarly, A smart beta ETF follows a smart beta index and is traded on the stock exchange.
Smart Beta vs Index Funds: Key Differences
- Cost: Index funds are relatively less expensive to manage, since there is not much decision-making involved. Smart beta funds require additional rules for selecting, weighting and periodically rebalancing stocks. As a result, their costs can be higher than those of a regular index fund.
- How easy to understand: Index funds are easy to understand, that is, the fund tracks a particular index. With a smart beta fund, you need to understand the factor being used and the rules behind it. That matters because different factors can behave very differently in different market conditions.
- Behaviour in different markets: Index funds move along with the broader market. Smart beta funds can behave differently depending on which chosen factor it follows. For example, a value strategy may perform well during one market cycle and lag the broader market during another.
- Diversification: Index funds such as broad-market index funds can provide exposure to a large group of companies. Smart beta funds can be more selective, so the portfolio may end up more concentrated depending on the strategy used.
This idea of picking a simple approach or a more detailed one is not limited to stocks. Even in commodities, such as Gold ETFs, investors face a similar choice. Do you want something simple, or are you comfortable with a bit more structure?
Which One Should You Pick?
There is no universally better choice. The right option depends on what you want from your investment.
If you prefer simplicity, broad market exposure and relatively low costs, a conventional index fund may be easier to stick with.
If you understand factors, are comfortable with a strategy that may behave differently from the broader market, and can stay invested even when the chosen factor goes through a period of underperformance, a smart beta fund could be worth considering.
However, you shouldn’t choose a smart beta fund simply because the word “smart” sounds better. A factor can underperform for long periods, and there is no guarantee that a particular factor will outperform the broader market in the future.
