What is smart beta investing strategy in equity MF?

Smart beta investing is a strategy that marries both passive as well as active investing. Beta, in general, refers to the volatility of an individual stock compared to some broader index such as Sensex or Nifty. Beta of a benchmark index such as Sensex is taken as one. Individual stocks are then compared with the movement of Sensex or Nifty and amount of deviation is termed as ‘beta’ of the stock. For example, if beta of a stock is 1.5 it means that stock price of the company will go up by 1.5 times of Sensex and vice-a-versa in case of Sensex falls.

So smart beta investing involves choosing, weighing and re-balancing stocks from the index that suits your investment objective and risk-taking ability. As Sensex value is calculated on the basis of free-float market capitalization, companies with the higher market cap are given more weight on the index. Similarly, the company with the lower market cap are given lower weight. 

There is no fundamental factor such as earnings growth or valuation ratios that is being taken into consideration while building such indices. Nevertheless, beta strategy removes this market cap bias and builds in objectivity. Stocks are selected on the basis of some common factors such as a company with lower volatility in earnings, lower earnings multiples, dividend record, return on equity or free cash flows. This mode of investment is also called 'factor investing' because it relies on identifying the key factors that drive stock selection and then using them to build portfolios. 

Factor-based investing is more suitable for investors looking for factor diversification and their goal is to earn more returns. According to a study done by S&P, the index based on momentum stocks has given an annualised return of 20.2 per cent and quality 20.7 per cent during October 2005 and June 2017, respectively, whereas the Sensex gave a return of 15 per cent. Similarly, low volatility index has the highest return-risk ratio of one, followed by the quality index at 0.99 and momentum index at 0.80 against 0.6 of the Sensex. But the ratio for value index was 0.53, signalling it carries a higher risk than the Sensex.

Various fund houses in India have rolled out such product in India such as Edelweiss, Reliance, ICICI Prudential and Kotak. In the last one year and six months, these smart beta ETFs have outperformed the ETF-based on Sensex and Nifty.

Historically, factor-based investing has been able to generate better returns than simple market cap-wise investment, however, there can be cyclicality attached to it in the short run. Therefore, it is better to have a combination of various factor-based investing to form a portfolio that smoothens the returns across different businesses and market cycles.