Will Adding Smart Betas To Profile Benefit Investors?

There’s no one rule or method to make money in the market, so no elixir to remedy all ills of investments. Within the broader game of investing, particularly in stocks, the approach is active vs passive. An active investment strategy is where the investment decisions are managed by an individual, usually a qualified & experienced fund manager to generate higher returns. In a passive strategy, there’s almost negligible role of any mediation and the investment is pre-fixed generally tied to an index and it mimics or imitates that benchmark, barring a minute percentage, called tracking error.

There are enough pros and cons within these strategies and would depend upon the investor’s objective to choose from. If one is trying to beat the benchmark, then active strategy is the only way while if one is content with the benchmark returns then a passive strategy works. But what if we could combine these both strategies to one’s advantage, that’s how the smart beta investments originated.

Cutting the jargon, one needs to be aware of some of the fundamentals. Alpha is a term described to measure the difference of actual returns from the expected ones i.e., excess return. Beta denotes the sensitivity or reaction of a particular stock or portfolio with respect to the overall market. It’s thus considered as the volatility or risk of a particular instrument. For instance, if an instrument generated 12 per cent return with a beta of 1.2 where the benchmark returns 10 per cent, the alpha is 2 per cent while beta is 20 per cent. It means to the instrument has exhibited 20 per cent excess volatility to generate 2 per cent additional return. Consequently, if the benchmark gained 10 per cent but the instrument has given only 8 per cent then it's considered to have lower alpha.

Traditionally, the benchmarks which the passives invest have weighting methodologies based on their market capitalisation (m-cap). M-cap means the total value of a company’s outstanding shares in the market, it simply represents the size of the company. The word ‘smart’ represents the enhancement of the passive strategies using factors. Factors are nothing but certain determinants or characteristics that influence the performance of a stock like that of nutrients and minerals in food.

The most common factors used are equal weighting where each security in the index is given equal weight irrespective of their m-cap. Fundamental weighting is based on factors like earnings, dividends, etc. Quality is another factor which allows the strategies to identify only those companies with better balance sheets and higher profitability. Factors like Price to earnings (P/E) and Price to Book (P/B) are considered as value while volatility or momentum could be the other factors where the former could be simple beta the latter considers the stock’s last one-year performance.

As more investors flock to passives, the addition of smart betas to the portfolio could add the necessary spring in their journey. They seem to combine the best of both worlds of active and passive management. Over sixty funds were launched in the last four years alone, that shows the gaining popularity of these strategies. Like I had cautioned in the beginning, no strategy offers panacea for investing hurdles. The post-pandemic markets are liquidity driven and thus factors like momentum, volatility, value have captured the gains and investor’s mind share while quality and equal weighted factors seem to have underperformed.

Though factors provide an alternate to human intervention, they too undergo cyclicality which is reflected in their past performance. For instance, Nifty 500 value has outperformed for three years since 2021, momentum had a rollercoaster ride with negative returns in 2022 though doing well in the other two years. However, value has underperformed with negative returns in 2019. So, investors rushing to add these to their portfolios should be wary of their limited journey in the market and should check their performance across the market cycle.

Another aspect to be considered is the costs i.e., the fund management fee. The very reason for approaching passive investment is to reduce costs but most smart beta are relatively expensive than their pure passives. Like all things in life, moderation is good in investing too and a diversified portfolio matching the risk profile of an individual is a must for a less-tiring investment journey.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])