Traditionally investors have been using indices in financial markets that are composed of assets based on their size or market capitalisation. Economist Harry Markowitz, through his Modern Portfolio Theory suggested construction of indices using other parameters rather than an asset’s size or its market capitalisation.
This approach is called Smart Beta Investing. In this article, we will study what smart beta investing is and how it can benefit investors.
What is smart beta investing?
Smart beta investing is a modern investing method of creating market indices or portfolios where stocks are selected based on factors like value, growth, momentum, etc. It is a combination of active and passive investing.
In traditional stock market indices, stocks are added to an index based on weightage that is given based on their market capitalisation. In smart beta portfolios, stocks can be selected based on a number of factors. These indices or portfolios are created to generate either more returns or the same returns with less risk than the benchmark index.
For example, the Nifty 50 index is created by adding 50 stocks, and the weightage of these stocks in the index is given on the basis of their market capitalisation. Whereas a smart beta portfolio might not necessarily give stocks weightage based on their market capitalisation, it might use other factors like value, quality, momentum, etc.
Also read: What are growth stocks
Smart beta investment strategies
There is no fixed method of creating smart-beta portfolios. Investors can form these portfolios in numerous ways. A single method or a combination of methods can create smart-beta portfolios. Some of the common factors used to select stocks in a smart-beta portfolio are:
- Value: Investors can give weightage to stocks in an index based on their price-to-earnings, price-to-book value, or any other financial ratios. This helps in choosing stocks that an investor might consider undervalued. Fundamental parameters can also be used to give more weightage to good quality stocks.
- Momentum: Momentum means buying stocks that have shown recent outperformance. Momentum can be used to weigh stocks in an index. Momentum-based portfolios can outperform in a bull market.
- Volatility: Investors can weigh stocks in an index based on their volatility. For example, stocks with lower volatility can be given more weightage or vice versa based on the underlying market conditions and risk preference of an investor.
- Dividend Yield: An index can also be created by weighing stocks based on their dividend yield—this way, companies with higher earnings can be given more preference.
These are just a few examples of how smart beta strategies can be employed. Investors can use a single method or combine two or more factors to create smart-beta portfolios.
Also read: Value investing in India
Benefits of using smart beta portfolios
Some smart beta portfolios can give investors an advantage over traditional portfolios such as:
- Outperformance: Some smart-beta portfolios may outperform traditional indices based on their factors and current market conditions. For example, in a bull market, a momentum-based market index can outperform a traditional index.
- Dynamic portfolio: Smart beta portfolios have a dynamic nature, meaning the weightage of stocks is changed based on the latest market conditions. These portfolios can adapt themselves to changing market conditions. For example, the weightage of high-momentum stocks in a portfolio will automatically start decreasing when the momentum begins to fade.
- Lower Risk: Investors can use smart beta strategies to reduce risk in a portfolio by giving more preference to lower volatility stocks or by including high-quality companies. Other methods like standard deviation or Sharpe ratio can also be employed.
- Diversification: Unlike traditional indices that might be concentrated in a sector or industry, smart-beta portfolios can be designed to be well diversified by introducing maximum limits on a certain sector. Diversification reduces stock or sector-specific risk.
- Transparency: Smart beta portfolios may seem complex, but they are not. They have very clearly defined rules for portfolio creation and are generally offered through ETFs. These rules are usually quantified and involve no human interference.
Also read: Diversification: Why it is important for your portfolio
Risks associated with smart beta portfolios
These factors need to be considered before using smart beta portfolios:
- Overfitting: Smart beta portfolios are thoroughly back-tested on historic data before getting deployed in real markets. There is a possibility that these portfolios are over-fitted or over-adjusted as per historical data to showcase superior returns and might not perform well in real markets.
- Factor risk: Factors used to create these portfolios might not work well in all market conditions. Some factors may get outdated due to changing market conditions. For example, momentum can reverse in a bear market, and portfolios can significantly underperform.
- Liquidity: A smart-beta portfolio can also have liquidity issues. For example, a portfolio with more weightage given to stocks with low valuation can face liquidity risk because low-valuation stocks are usually less liquid.
Conclusion
Smart-beta portfolios have the potential to outperform traditional stock market indexes. A smart-beta portfolio must be thoroughly tested on historical data, and its rules must be clearly defined. Investors should also understand the risks associated with smart-beta portfolios, as in some cases, these can be highly risky. Investors should also understand that there is no guarantee that a smart-beta portfolio will outperform the market. You can learn more about smart-beta portfolios by trying to create your own virtual smart-beta portfolios on StockGro’s paper trading platform.
FAQs
1. What is smart beta investing?
Smart beta investing is a modern way of creating stock market indices. Traditionally, indices are created based on the market capitalisation of stocks. However, a smart-beta portfolio uses other factors rather than market capitalisation to weigh stocks in an index.
2. Are smart beta strategies risky?
Yes, smart-beta portfolios can be risky. Some smart beta portfolios that are designed to chase higher returns can have more risk than traditional indexes. Whereas some portfolios are designed specifically to lower risk for the same level of returns.
3. Can you invest in smart beta portfolios in India?
Yes, many asset management companies in India offer smart beta portfolios either through mutual funds schemes or ETFs. Investors can visit the websites of AMCs to understand the smart beta products in detail and understand their methodology and risk profile.
4. What are smart beta ETFs?
Like index mutual funds track a stock market index, Smart beta ETFs track a smart beta portfolio. Investors follow these ETFs or can use them as benchmarks for their strategies. AMCs can have their ETFs.
5. How can investors choose the right smart beta ETF?
An investor must first understand the methodology of selecting stocks in a certain ETF, then investors must look at the risk profile, and then the historic performance of the ETF must be carefully studied to understand how the ETF performed in various market conditions.
