What Are Smart Beta ETFs?
If you have been exploring different ways to invest in the equity market efficiently, you may have come across the idea of smart beta. Over the past few years, smart beta ETFs have become popular across global markets, and Indian investors are gradually adopting them as well. These funds offer a blend of the systematic nature of passive investing with the targeted exposure of factor-based strategies. This combination appeals to investors who want more control over the characteristics they hold in their portfolio without relying on fully active management.
Smart beta ETFs aim to provide diversified, rules-based exposure to specific factors such as value, quality, momentum, low volatility, or size. This allows you to move beyond simple market-cap weighting and access investment styles that were earlier available mainly through active funds.
In this blog, you will learn what smart beta ETFs are, how they work, the types of strategies they follow, their benefits and risks, how they differ from traditional ETFs, how their taxation works in India, and why investors may consider adding them to long-term portfolios.
What Is a Smart Beta ETF?
A smart beta ETF is a type of exchange-traded fund that uses a transparent, rules-based methodology to select and weight securities. Instead of following a market-cap weighted index, a smart beta fund tracks an index that applies factor-based rules. These rules might focus on financial strength, valuation, stability of earnings, historical price characteristics, or other factor signals.
Unlike traditional passive funds, smart beta ETFs tilt the portfolio deliberately toward selected characteristics. Yet, unlike active funds, they apply these tilts through fixed rules that avoid subjective judgement. This structure helps you maintain discipline while still gaining exposure to investment themes that may improve long-term risk-adjusted returns. By design, smart beta ETFs attempt to deliver a more balanced or efficient approach to equity investing.
Types of Smart Beta ETFs
Smart beta strategies come in several forms. Each type applies a different rule-set for deciding which companies enter the portfolio and how they are weighted.
Equal Weighted ETFs
These ETFs assign the same weight to every stock in the index. By doing so, they reduce concentration in the largest companies and give more representation to mid-sized and smaller companies.
Fundamentally Weighted ETFs
These strategies rely on financial indicators such as sales, earnings, book value, or dividend strength. Weight is assigned based on the strength of these fundamentals rather than market size.
Factor-Based ETFs
Factor investing focuses on specific attributes that research links to long-term performance. Common factors include value, quality, momentum, size, and dividend yield. Each ETF targets a specific factor or set of factors to achieve a particular style of exposure.
Low Volatility or Minimum Variance ETFs
These ETFs select companies with historically stable price movements. The goal is to reduce fluctuations in portfolio value while still participating in equity growth.
Multi-Factor ETFs
These funds combine two or more factors to balance risk and return. For example, a fund may combine momentum with quality or value with low volatility. Multi-factor ETFs often aim for more consistent performance across market cycles.
When evaluating a smart beta ETF, it is important to understand which factor it follows, how the index is constructed, and what weighting rules are used. These choices directly affect the behaviour and performance of the fund.
Also Read: What is an Exchange Traded Fund (ETF)? - m.Stock
How Smart Beta Differs from Passive and Active Management?
Traditional passive ETFs track market-cap weighted indices with minimal discretion. Active funds rely on fund managers to make security-level decisions. Smart beta ETFs occupy a middle ground. They remove human discretion by using pre-set rules, yet they incorporate active-style insights by targeting specific factors. Because rules are fixed, the costs remain lower than active funds, while offering more targeted exposure than simple passive strategies.
However, smart beta ETFs should not be treated as purely passive. Each ETF embeds a deliberate factor tilt, and performance will differ from broad indices. Understanding the rule-set is essential before investing.
Also Read: What is the Difference Between Active & Passive Funds? |m.Stock
Benefits of Smart Beta ETFs
Smart beta ETFs offer several advantages for investors seeking a structured, objective approach to equity investing.
Diversification
Smart beta funds often spread exposure across a wider set of companies and factors rather than concentrating on the largest companies.
Transparency
Selection and weighting rules are published in advance. This helps you understand how the portfolio is built and why certain stocks are included.
Cost Efficiency
Smart beta ETFs usually carry lower fees than active funds. You receive factor-based exposure at a relatively low cost.
Targeted Exposure
You can choose a smart beta ETF that fits your specific goal. Investors looking for stability may opt for low volatility strategies, while those inclined towards growth may select momentum or quality strategies.
Potential for Better Risk-Adjusted Returns
Certain factors have historically offered improved performance relative to risk. Smart beta ETFs try to harness such patterns through disciplined, rules-based investing.
Risks of Smart Beta ETFs
Smart beta ETFs also involve certain risks that you should understand before investing.
Strategy Complexity
Factor investing can be less intuitive than traditional market-cap investing. Without clear understanding, you may select a strategy that does not match your objectives.
Shorter Track Records
Some factors or indices may have limited history in India, making long-term performance assessment difficult.
Sector or Style Bias
Factor tilts can lead to unintended concentration. For example, value funds may overweight cyclical sectors while low volatility strategies may tilt toward defensive stocks.
Possibility of Underperformance
Factors go through cycles. There may be long periods when broad indices outperform factor strategies.
Tracking Error
Because smart beta ETFs deviate from market-cap indices, their performance will not mirror the broad market. This can be beneficial or adverse depending on market conditions.
Difference Between Market Cap Weighted ETFs and Smart Beta ETFs
Market cap ETFs assign weight based on company size. Smart beta ETFs assign weight based on factors, fundamentals, or equal weighting. This changes the overall exposure profile. Smart beta funds aim to provide improved risk-adjusted returns by emphasising characteristics other than size. However, factor tilts may also introduce differences from benchmark behaviour, which investors must be comfortable with.
Why Investors Choose Smart Beta ETFs
Many investors opt for smart beta ETFs for reasons such as:
- The desire to improve long-term returns through factor investing
- Better risk management through low volatility or quality strategies
- Transparent and systematic rules
- Lower cost compared to actively managed funds
- Ability to align exposure with specific financial goals
- Use as a satellite allocation alongside core index funds
The availability of new smart beta ETFs in India has made access to factor-based strategies more convenient. These funds are now suitable for both new and experienced investors seeking diversified, rules-driven exposure.
Smart Beta vs Thematic or Commodity ETFs
Thematic ETFs focus on specific industries or long-term themes. Commodity ETFs track commodity prices. Smart beta ETFs, however, use factor-based rules to select stocks. They are not tied to sector themes or commodity movements. Instead, they try to capture structural characteristics that may influence long-term performance. This places them between simple passive investing and thematic strategies in terms of risk and consistency.
Taxation on Smart Beta ETFs
The tax treatment of smart beta ETFs in India depends entirely on the nature of the underlying assets and the fund's equity allocation. You should identify whether the ETF qualifies as an equity-oriented fund.
1. Equity-Oriented Smart Beta ETFs
These are ETFs where at least 65% of the assets are invested in domestic equities or equity-related instruments.
Gain Type | Holding Period | Tax Rule |
|---|---|---|
Short Term Capital Gains (STCG) | Units sold within 12 months | Taxed at 20% plus applicable surcharge and cess (applies to transfers on or after 23 July 2024) |
Long Term Capital Gains (LTCG) | Units sold after 12 months | Taxed at 12.5% on gains exceeding ₹1.25 lakh in a financial year, without indexation benefit. |
Dividends | Income from dividends | Added to your total income and taxed at your applicable slab rate. |
Note: The LTCG exemption threshold of ₹1.25 lakh applies to the aggregate LTCG from all listed shares and equity-oriented mutual funds/ETFs in a financial year.
2. Non-Equity Oriented Smart Beta ETFs
These include rules-based funds that are less than 65% in domestic equities, such as:
- Global Smart Beta ETFs (investing in US/EU/other international factors).
- Debt-focused Smart Beta strategies.
- Hybrid/Multi-Asset funds with low domestic equity exposure.
The taxation for these funds depends on the purchase date, but the most recent rules simplify the treatment for newer investments:
Gain Type | Holding Period | Tax Rule |
|---|---|---|
Short Term Capital Gains (STCG) | Held for less than 24 months or any duration when the units were purchased on or after 1 April 2023. | Gains are added to your total income and taxed at your applicable income tax slab rate. |
Long Term Capital Gains (LTCG) | Held for 24+ months (acquired before 1 April 2023, sold after 23 July 2024) | Taxed at 12.5 percent without indexation, plus surcharge and cess as applicable. |
Dividends | Income from dividends | Added to your total income and taxed at your applicable slab rate. TDS of 10% is deducted if the amount exceeds ₹5,000 in a financial year. |
Conclusion
Smart beta ETFs are a structured way to gain factor based exposure without relying on traditional active management. They combine transparency, discipline, diversification, and cost efficiency with the potential benefits of factor investing. For Indian investors, they offer access to styles that can complement core equity exposure and refine long-term portfolio construction.
However, smart beta ETFs are not risk free. They involve complexity, potential concentration, factor cycles, and tracking differences from broad markets. Performance depends on the effectiveness of the factor, the quality of index construction, and your investment horizon.
If you are willing to study the underlying methodology, evaluate the factor behaviour, and remain invested for the long term, smart beta ETFs can be a valuable part of your investment strategy. As always, ensure that the chosen ETF aligns with your goals, risk tolerance, and tax considerations.
Also Read: Smart Beta ETF vs Traditional ETF: Types & How They Work | m.Stock
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FAQ
How do smart beta ETFs differ from traditional ETFs?
Traditional ETFs track market-cap weighted indices where the largest companies dominate portfolio weight. Smart beta ETFs follow rule-based indices that assign weight based on factors such as value, momentum, quality, or volatility. This leads to a portfolio that may behave differently from the broad index.
What are the most common weighting strategies used in smart beta ETFs?
Common strategies include equal weighting, fundamental weighting, factor-based weighting, low volatility weighting, and multi-factor weighting. Each strategy follows specific rules that determine stock selection and weight.
Are smart beta ETFs risky?
Yes. Although they aim to improve risk-adjusted returns, smart beta ETFs can involve style concentration, sector biases, and periods of underperformance. Some may also have limited historical data in India.
How can I invest in smart beta ETFs in India?
You can invest through any brokerage account that offers access to the NSE and BSE. Many fund houses also provide index fund versions of smart beta strategies, which allow investments through SIPs.
Do smart beta ETFs guarantee higher returns?
No. They aim for better risk-adjusted returns, but outperformance is not guaranteed. Performance varies depending on the factor, market cycle, and index design.
Which smart beta ETFs are popular in India?
Common examples include ETFs based on value, momentum, quality, low volatility, and multi-factor indices. Many Indian asset managers offer these strategies today.
Can I use SIPs for smart beta investing?
If the AMC offers a mutual fund or index fund version of the same strategy, you may invest using SIPs. ETFs themselves must be bought on the exchange.
Are smart beta ETFs suitable for new investors?
They can be. However, understanding factor behaviour is important. New investors should select simpler strategies or begin with modest exposure.
Are smart beta ETFs more expensive than regular ETFs?
They generally have slightly higher expense ratios than market-cap ETFs due to additional computation and index design. Even so, they are usually cheaper than actively managed funds.
How often do smart beta ETFs rebalance?
Rebalancing is rule-based and usually occurs quarterly, semi-annually, or annually depending on the index. Rebalancing ensures the fund remains aligned with the chosen factor strategy.