How to Build a Smart Beta Portfolio Using ETFs and Factor-Based Strategies

Building a Smart Beta portfolio offers investors the chance to capture market returns while strategically targeting specific factors like value, momentum, quality, and volatility. Unlike traditional index investing, which follows a market-capitalisation-weighted approach, Smart Beta portfolios focus on factors that can help optimise returns over time. 

In this blog, we’ll explore how to construct a Smart Beta portfolio using ETFs and factor-based strategies, as well as the benefits and risks associated with this approach to passive investing.

What is a Smart Beta Portfolio?

A Smart Beta portfolio combines the benefits of both passive and active investing strategies. Unlike traditional index investing, which tracks a market-capitalisation-weighted index, a Smart Beta portfolio targets specific factors that have historically outperformed the market. These factors can include value, momentum, quality, and volatility, among others.

The main objective of a Smart Beta portfolio is to enhance returns while maintaining the cost-effectiveness and transparency of passive investing. By selecting stocks based on these predefined factors, Smart Beta strategies aim to capture systematic risk premiums and generate better risk-adjusted returns than traditional indices.

Key Factors in Smart Beta Strategies

Smart Beta strategies are based on targeting specific factors that have historically shown the potential to outperform the broader market. The most common factors used in Smart Beta strategies include:

1. Value: This factor targets undervalued stocks that are trading at a lower price relative to their fundamentals. By focusing on these stocks, investors aim to capture long-term capital appreciation as the market corrects their undervaluation.
   
2. Momentum: Momentum investing focuses on stocks that have shown strong performance over a set period. The idea is that stocks with positive momentum will continue to perform well, capitalising on the continuation of current trends.
   
3. Quality: The quality factor focuses on companies with strong financials, high profitability, and a proven track record of stable earnings. These companies are often less volatile and can offer more consistent returns over time.
   
4. Volatility: Low-volatility stocks are less sensitive to market swings, making them ideal for investors looking to reduce risk. The goal is to capture returns with less price fluctuation compared to the broader market.

By focusing on these factors, Smart Beta strategies aim to achieve better risk-adjusted returns than traditional market-cap-weighted index investing.

How Smart Beta ETFs Work

Smart Beta ETFs are exchange-traded funds that track indices based on specific factor-based strategies. Here’s how they work:

• Factor-Based Strategies:
  Smart Beta ETFs select stocks based on factors like value, momentum, quality, and volatility. These factors are designed to capture higher returns and improve risk-adjusted performance.
  
• Passive Management:
  Smart Beta ETFs are passively managed, meaning they follow a set of rules without active decision-making by fund managers. This approach reduces costs while still targeting factors that can outperform the market.
  
• Low-Cost:
  Since Smart Beta ETFs do not require active management, they are cost-effective compared to traditional actively managed funds.
  
• Systematic Approach:
  The ETFs follow a systematic approach based on predefined rules, allowing for transparency and consistent execution of the factor strategy.
  
• Potential for Outperformance:
  By focusing on factors that have historically delivered higher returns, Smart Beta ETFs offer the potential to outperform traditional indices.

Benefits of Smart Beta Funds vs. Actively Managed Mutual Funds

Smart Beta funds offer several advantages compared to actively managed mutual funds. Here’s a comparison of the two:

• Cost-Effectiveness: Smart Beta funds are passively managed, which means they have lower fees compared to actively managed mutual funds. This cost efficiency can help improve overall returns, especially over the long term.

• Transparency: Smart Beta ETFs follow rules-based strategies that are transparent, allowing investors to clearly understand the methodology behind stock selection. In contrast, actively managed mutual funds may have less transparency in terms of decision-making.

• Consistent Strategy: With Smart Beta ETFs, the strategy is fixed, meaning the fund’s approach does not change unless the rules are adjusted. In actively managed funds, strategies can shift based on the fund manager’s discretion, which can lead to inconsistency.

• Potential for Outperformance: Smart Beta funds aim to target specific factors that have shown to outperform traditional market indices. Active managers may also try to outperform, but their success depends on their ability to correctly time the market or choose winning stocks, which is more challenging and costly.

• Lower Risk: While both options aim to outperform the market, Smart Beta funds typically take a more diversified approach, which can help manage risk better than actively managed funds that focus on a narrower selection of stocks.

Smart Beta ETFs Available for Indian Investors

Indian investors have access to a range of Smart Beta ETFs. Here are some examples and how they cater to specific factors:

• Nifty Alpha 50: Focuses on the alpha factor, targeting stocks with strong relative performance over the market. It’s suitable for investors looking to capture stocks with high growth potential and strong momentum.

• Nifty Next 50: Includes mid-cap stocks that are expected to be the next big performers. This ETF focuses on stocks with strong growth potential but lesser coverage than the Nifty 50.

• Nifty 100 Low Volatility 30: Targets low-volatility stocks, aiming to provide stable returns with lower risk. This ETF is ideal for conservative investors looking for steady performance with minimal fluctuations.

• Smart Beta ETFs in India: Indian investors can also look for other sector-specific or factor-based ETFs that target growth or value stocks, depending on their portfolio strategy.

These Smart Beta ETFs provide Indian investors the opportunity to build a diversified portfolio with a factor-based approach that can help enhance long-term returns.

Risks Involved in Factor-Based Investing Using Smart Beta Strategies

While Smart Beta strategies offer many potential benefits, they also come with certain risks. Here are the key risks associated with factor-based investing using Smart Beta strategies:

• Factor Underperformance: Factors like value, momentum, and low volatility may not always outperform the market. For instance, value stocks might underperform during growth cycles, and momentum strategies can falter during market corrections.

• Market Cycles: Smart Beta portfolios are subject to market cycles, meaning the factors that work well in one market environment may not work in another. For example, a momentum strategy might outperform in a trending market but could lag during sideways or volatile periods.

• Concentration Risk: Certain Smart Beta ETFs may end up concentrated in specific sectors or stocks that are highly correlated, which could increase the risk of large losses if those sectors or stocks perform poorly.

• Tracking Error: While Smart Beta ETFs aim to replicate a factor-based index, they may not always track the index perfectly, leading to tracking error. This could result in slight deviations in performance compared to the benchmark.

• Over-reliance on Historical Data: Many Smart Beta strategies are based on the historical performance of specific factors. While these factors have worked in the past, there’s no guarantee they will continue to provide superior returns in the future, especially as market conditions evolve.

Diversification in Smart Beta Portfolios

Diversifying within a Smart Beta portfolio is crucial to ensure balanced risk and improve the potential for long-term returns. Here’s how you can achieve diversification:

• Combine Multiple Factors: Instead of focusing on a single factor, combining Smart Beta ETFs targeting value, momentum, and quality can reduce the risks associated with any one factor underperforming. A diversified approach ensures that if one factor lags, others may still perform well.

• Sector Diversification: Invest in Smart Beta ETFs that track multiple sectors. This reduces the concentration risk of being heavily exposed to a single industry or market segment.

• Geographical Diversification: While many Smart Beta ETFs are based on Indian indices, consider adding international Smart Beta ETFs to your portfolio. This way, you can tap into global growth opportunities and reduce the risk tied to the Indian market.

• Balancing with Traditional Index Funds: While Smart Beta strategies offer targeted returns, it’s important to balance them with traditional index funds for broader market exposure. This can provide stability while maintaining the potential for outperformance through factors.

By combining different Smart Beta ETFs and diversifying across factors, sectors, and geographies, investors can create a well-rounded portfolio that balances risk and maximises growth potential.

Building a Diversified Smart Beta Portfolio for Long-Term Growth

Smart Beta portfolios offer an innovative way to gain targeted exposure to factors that have the potential to outperform traditional market indices. By combining factors like value, momentum, quality, and volatility, investors can optimise their portfolios for better risk-adjusted returns.

However, it’s important to recognise the risks associated with Smart Beta strategies, such as factor underperformance or market cycle shifts. Diversifying across multiple factors, sectors, and regions can help mitigate these risks and create a well-rounded, long-term investment strategy.With Streetgains‘ data-driven insights, investors can identify the best Smart Beta ETFs and factor-based strategies to optimise their portfolios, ensuring that their investment goals are aligned with their financial objectives.