Passive investment: Is outperformance possible?

The term "beta" is simply a measure of a stock's sensitivity to the movement of the overall stock market. Theoretically, a stock with a beta reading of one means it will move in tandem with the benchmark index, and a stock with a reading of 1.2 means it is 20 percent more volatile than the market.

So, there is room to construct a rule-based index, to reflect a superior risk-reward ratio in order to enhance returns, improve diversification and reduce risk by incorporating one or more predetermined factors. This exercise, to alter the beta of an index to outperform a benchmark index, is called ‘smart’ beta. Low volatility (lower variation in price), value (stocks relatively cheaper), quality (consistent growth irrespective of the business cycle), or momentum (following the trend) are the traditional factors used in creating a smart beta index.

Generally, most ETFs are market capitalization-based. However, tweaking an index on the basis of rule-based factor(s) involves human intervention by way of choosing criteria that are used to filter stocks from an index. In this sense, smart beta differs fundamentally from a traditional passive indexing strategy. As a result, it is also called a crossover category as it lies between active and passive investment.

Oakland Athletics, a relatively unknown baseball team in the USA, created history by winning 20 consecutive games in 2002 in the American League, surprising both fans and experts. The reason for this was their team manager. He selected the team based on sabermetrics, a statistical approach to select a player based on their historical performance.

‘Smart’ beta fund is quite analogous to the sabermetrics technique, where stocks are selected based on certain factors. Data over the years have shown that such smart beta indices tend to deliver a higher return. For example, in the case of the Nifty Alpha Low Volatility 30 index, the 30 stocks will be picked from the Nifty 100 and Nifty Midcap 50 indices using two parameters – alpha and low volatility with equal weight. The weight of each stock in the index is based on an equal-weighted combination of its Alpha and Volatility score.

There is a growing appetite among HNI, institutions, and other retail investors for smart beta/index fund ETFs, thanks to the various indices introduced by the NSE and asset managers providing funds based on these indices. Thus far, most of the smart beta offerings are based on low volatility, momentum, value, and quality indices provided by NSE. It must be noted that the smart beta ETFs launched by different AMCs could have the same underlying strategy index, but they can have varied returns due to tracking error and different expenses ratios.

The smart beta indices based on the four factors mentioned above have delivered 11-18 percent CAGR in the last decade, compared with the 9 percent of the Nifty 50 index. The expense ratio of the 'smart' beta funds ranges between 0.2-0.4 percent, thus making it a low-cost high-impact product. Just like other equity strategies which are available, the smart beta product can be a part of one’s core equity portfolio for long-term wealth creation. Investors who can understand the underlying concept, based on their risk appetite, can explore investing in such products. Further, they can seek the advice of a financial advisor.