As an investor, you must have often been told to be smart about your investment, to take emotions out of the equation and invest in a non-reactive and informed manner. At the same time, we all know how challenging it is to be smart about our investments and consistently generate good returns while staying within our risk parameters.
Reining in volatility
The performance of the stock market is measured by the performance of the benchmark indices. For example, in India, if S&P BSE Sensex and Nifty50 gain, then it is said that the market has performed well and vice-versa. Then, there is the performance of individual stocks that comprise the benchmark indices. Some stocks generate returns in line with the benchmark; while other generate higher or lower returns.
Alpha refers to the excess return that an investment generates relative to the return on the benchmark index at a given risk level.
Risk indicates the inherent volatility of an asset and can be measured by beta. Similar to performance, when it comes to volatility, some stocks are more volatile than the benchmark, some are less, and some are the same. If a stock’s performance, on an average, has been more volatile than the benchmark, then its beta will be higher than 1. For example, a stock with a beta of 1.2 would be 20% more volatile than the market. Thus, if the benchmark goes up by 10%, the stock is likely to go up by 12%. The reverse is true as well: if the benchmark falls by 10%, the stock will witness a steeper fall of 12%.
The middle ground
Generally, fund managers are known to either follow a passive fund management strategy or an active fund management strategy. In a passive strategy, fund managers replicate the benchmark portfolio, i.e. hold the same securities that are there in the benchmark and in the same proportion. Thus, the beta of passive funds would usually be close to 1. The goal of passive strategies would be to generate returns in line with the benchmark.
On the other hand, the goal of active fund managers is to exceed benchmark returns. To achieve this, they follow an active strategy of stock selection. As a result, an actively-managed portfolio may have a beta higher than 1.
Does that mean that you can generate higher returns only if you take on more risk? That is where smart beta strategies come in. They offer the middle path. They aim to maximise returns while attempting to minimise risk.
At the core, smart beta strategies passively follow select smart beta indices. Smart Beta indices select stocks based on one or more factors like volatility, momentum, value, dividend yield, quality etc. This means from within the investable universe, these strategies give more importance to certain factors and the stocks linked to those factors generally tend to have a higher weightage in the portfolio.
For example, a smart beta strategy focused on the factor ‘value’ selects stocks which have relatively lower valuations compared with the rest of the stocks in the investable universe. Similarly, a smart beta strategy focused on low volatility will overweigh stocks that have lower volatility compared with the other stocks in the universe. This way, smart beta strategies seek to enhance returns by passively replicating indices that have been formed based on certain criteria.
From an investor’s perspective, smart beta funds can be a part of the core portfolio. That is because, such funds combine the benefits of both passive and active investment strategies, while being a relatively low-cost way to get some exposure to quasi-active funds. However, do remember, any allocation to smart beta equity funds should be considered only as part of your overall asset allocation strategy.
The popularity of smart beta funds are growing globally, and are finding acceptance across all categories of investors in India too. It’s worth trying out these innovative smart beta funds as part of your overall equity allocation.
(Chintan Haria is Head of Product Development & Strategy at ICICI Prudential AMC. Views are his own)