Smart Beta Strategies: What Investors Should Know Before Investing
As of August 2025, Indian mutual fund AUM is sitting at around ₹77 lakh crores and is on its way to cross ₹100 lakh crores very soon.
Over the years, there has been a noticeable shift towards passive investing strategies. As per BCG’s Global Asset Management Report 2025, the asset management industry is experiencing a structural shift towards passive management. The Active AUM in mutual funds and ETFs fell from 65% in 2023 to 61% in 2024.
The growth of passive investing is there. However, not all of this growth is coming from traditional market cap weighted passive indices.
A large chunk of the inflows has been towards what are commonly referred to as smart beta funds. These funds try to combine passive and active investing in an attempt to deliver a positive alpha.
Smart beta indices are created to capture some factor exposure. Factors, in simple words, are the drivers of returns in the market.
Think of it in terms of a simple x and y equation:
- a student’s score in the exam is a function of study hours;
- crop yield is a function of rainfall, soil quality, and temperature;
- a company’s sales are a function of marketing spend, etc.
Returns in the markets are a function of these systematic risk factors – an investor gets compensated for taking exposure to these systematic risk factors.
NSE began introducing strategic indices designed to provide exposure to these risk factors, which quickly attracted investor attention. Some of the popular smart beta indices that you might have heard of include – Nifty200 Momentum 30, Nifty100 Low Volatility 30, Nifty500 Value 50, etc.
The growth in the number of index funds & ETFs replicating the performance of these indices was such that BSE also jumped on the bandwagon and introduced several new smart beta indices similar to NSE’s in May 2025.
As of August 2025, there are more than 70 ETFs and index funds tracking these indices and over ₹30,000 crores in AUM.
The primary driver of this growth is the promise of superior returns that these smart beta indices offer. If you look at the factsheet of any of these smart beta indices, you will notice returns much higher than the traditional Nifty 50 index. While the latter promises returns somewhere in the range of 12%, a lot of these smart beta indices have historical returns closer to 20%.
While these returns may seem tempting, there are a few things investors should know before investing.
What Investors Should Know Before Investing
Simulated performance:
The attractive returns that seem to lure investors towards these funds are not live market performances.
Smart beta indices are a fairly new breed and have very limited live track records. The long-term average returns that you see on factsheets are simulated historical returns.
While this doesn’t necessarily diminish their future potential, investors should understand their limitations – historically simulated returns introduce a lot of biases into the performance history and may not be the most reliable indicator of how future performance will unfold.
True to label:
The essence of these factor funds is in the fact that they give investors the exposure to the factor that is on its label. If you are investing in Nifty50 Value 20, you expect to get exposure to the value factor. But do you really?
A study titled Factor Indices in India: Exposures and Style Analysis explored whether the smart beta indices in India are true to their label i.e., do they really provide investors the true factor exposure that they intend to.
The study found that while some factor indexes did display statistically significant exposure to their intended factor, several outright failed to do so. For example, the study found that while NIFTY500 Value 50 and SP BSE Enhanced Value showed positive and significant exposure, NIFTY50 Value 20 showed no statistically significant exposure.
Similarly, while NIFTY200 Quality 30 and SP BSE Quality showed positive and significant exposure, NIFTY Midcap150 Quality showed no statistically significant exposure to the quality factor.
Multi-factor indices like NIFTY Alpha Quality Value Low Volatility showed no statistically significant exposure to several factors they have on their label.
All of the smart beta indices were found to have very high correlation (0.91) with the overall market. Thus, the market itself is doing most of the heavy lifting and what seems like a factor fund is mostly market exposure with a pinch of factor sprinkled on top.
Illusion of outperformance
The performance of some of these factor funds in the recent past has been nothing short of incredible. For instance, Nifty500 Value 50 over the past 5 years has generated close to 36% returns compared to just 18% (which is great by the way) of Nifty 50.
But is this really outperformance?
Comparing the absolute returns of these smart beta indices with a broad-based market index like Nifty 50 is not fair since the risk exposures can be very different. Remember, the markets compensate investors for taking on risk factors…the more exposure to these risk factors you take, the higher should be the compensation.
Thus, in order to truly check whether these smart beta funds outperform traditional broad-based indices like Nifty 50, you have to compute alpha (which accounts for this risk exposure).
A research study conducted by Andrew Clare, Nick Motson, and Steve Thomas from Cass Business School, City University London found that while it was true that these factor indices did outperform the standard cap-weighted index in absolute terms, this outperformance was not alpha.
Smart beta indices often have very concentrated risk exposures i.e., they tend to hold very similar types of companies thereby increasing the risk of investments. So, the higher performance you are seeing on paper is not true alpha but a compensation for taking on higher risk.
Cyclicality
Nassim Taleb in his bestseller, The Black Swan: The Impact of the Highly Improbable, used a beautiful analogy to explain how averages can mask extremes in statistics.
He infamously quoted – “Don’t cross a river if it is four feet deep on average.”
If you’re 5’5″, would you cross a river that averages four feet in depth?
The answer is an obvious no!
While the river may be four feet deep on average, it may be eight feet deep on one end and shallow on the other making the average four.
If you stepped into the deep end, you would end up drowning yourself.
The performance of a lot of these smart beta funds looks amazing when viewed on average – 3-year average, 5-year average, average return since inception. However, there are deep ends that you must be wary of before stepping in. The performance of these smart beta funds is highly cyclical with extreme drawdowns – not for the faint of heart.
Tracking difference
Tracking difference is a measure of how closely your index fund or ETF is able to mirror the performance of the underlying benchmark that it is trying to replicate. It is computed as the difference between the index’s returns and the fund’s return.
For smart beta funds, this tracking difference can be especially high because most of the liquidity in India is concentrated in just the top 100 companies and smart beta indices often have a lot of securities outside this list.
On top of that, unlike the semi-annual rebalance of Nifty 50, most smart beta indices have quarterly rebalanced which means higher turnover contributing to a higher tracking difference.
For example, the Motilal Oswal BSE Enhanced Value Index Fund has underperformed its benchmark by 1.41% annually over its 3+ year track record. Similarly, Tata Nifty Midcap 150 Momentum 50 Index Fund has underperformed the underlying benchmark by 1.2% since launch.
These tracking difference can eat up a lot of your gains and can create a massive impact on the terminal value of your investments.
Bottom Line
Smart beta funds have gained immense popularity due to their promise of superior returns, but investors need to look beyond the marketing materials. The impressive historical performance is largely backtested, many funds fail to deliver true factor exposure, and the apparent outperformance often comes with significantly higher risk rather than genuine alpha generation.
These funds are highly cyclical with substantial drawdowns and often struggle with tracking differences due to liquidity constraints and frequent rebalancing. While smart beta investing does hold potential as part of a diversified portfolio, investors should approach these funds with realistic expectations, understand the underlying risks, and avoid getting swayed by simulated historical returns.
Before investing, carefully evaluate whether you truly need factor exposure, can handle the volatility, and are comfortable with the additional costs. Remember, there’s no free lunch in investing – higher returns typically come with higher risks attached.
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