Investors often come across contradicting arguments in favour of passive investing and active investing. Some experts recommend the former while others swear by the latter. But what if you are unable to choose between the two? Shouldn’t there be a way to get the best of both worlds?
There is–Smart Beta strategies.
But before we begin exploring smart beta investing strategies, let’s first understand what beta means.
Generally, the risk of investing in equities is measured via beta. It measures the volatility, which is the fluctuation in the investment value, compared to benchmark indices like Nifty.
A beta value of 2 means the stock or portfolio value is expected to change by twice as much the change in the value of the Nifty–either in a positive or negative direction. Thus, higher the beta, the riskier the investment. A small positive or negative change in the benchmark index will result in a large change in the value of the investment.
What are Smart Beta strategies
Smart Beta strategies aim to increase the return potential without increasing risk. They take the same amount of risk as the benchmark indices but increase the return potential by using better screening or weighting criteria.
For example, Nifty is an index consisting of 50 large-cap stocks weighted by their market cap. Thus, stocks like TCS and Infosys that have huge market caps get higher weightage in the index. A higher weight means that proportionately more money will go into these stocks when you invest in Nifty. Thus, a negative change in the stock price of TCS or Infosys will impact the overall investment in a big way, compared to the same amount of negative change in other smaller market cap stocks.
On the other hand, if we use an equal-weighted scheme, every stock gets an equal amount of investment, instead of market cap scheme on the same 50 stocks in the Nifty. In this case, a negative change of equal amount in the stock prices of all the stocks will have the same impact, irrespective of their market cap.
Such a strategy is an example of a smart beta strategy. You invested in the same set of stocks, but by smartly changing the allocation of money (weight) among the stocks you are able to increase the return potential without taking higher risks.
Investing in Smart Beta smallcases
On our platform, you can find four such smart beta strategies. All of these strategies select stocks only from the top 150 stocks by market cap listed on Nifty. They are inherently passive in nature, as you are required to change stocks and weights only once a quarter or year. But all of them use different quantitative weighting schemes to decide the allocation of money among the stocks.
These strategies are designed to generate market-beating returns (more returns than the broad market indices like Nifty) without taking more risk compared to investing in Nifty. They are the perfect way to create long-term wealth through equities.
The following video explains Smart Beta strategies in detail.
You can find following four smart beta strategies on our platform. Check out the full collection here.
Quality – Smart Beta
Screening criteria: The Quality – Smart Beta smallcase tries to select the businesses or companies that can stand the test of time by using fundamental ratios like return on equity, debt to equity, earnings variability and accrual. Stocks are only selected from the top 150 market cap companies.
Quantitative weighting scheme: This smallcase uses a methodology called sharpe maximization. Sharpe ratio measures the returns generated per unit of risk. Risk means the volatility or fluctuation in the investment value. If a portfolio has a higher sharpe compared to another portfolio, it means that it can generate more returns but with the same amount of fluctuation in the investment value. Higher the sharpe, better the portfolio. The quantitative method decides the weights of the stocks in the portfolio in a manner that maximizes the sharpe ratio.
Growth – Smart Beta
Screening criteria: Companies experiencing high earnings growth and consistently generating profits are selected from the top 150 market cap companies for the Growth – Smart Beta smallcase. Such companies are called growth companies. These companies have better opportunities to reinvest their earnings and generally command higher valuations.
Quantitative weighting scheme: This smallcase uses a minimum volatility weighting methodology. Volatility or risk measures the magnitude of fluctuations in the investment value. Lower the volatility, lesser the fluctuations and smoother your investment journey. The risk that the portfolio could be down when you suddenly want to exit is minimized. The quantitative method decides the weights of the stocks in the smallcase to minimize the overall risk and volatility.
Low Risk – Smart Beta
Screening criteria: The least volatile stocks among the top 150 market cap stocks are selected for the Low Risk – Smart Beta smallcase.
Quantitative weighting scheme: This smallcase uses a maximum diversification weighting scheme. Diversification is the art of investing in instruments that are not correlated. For example, all IT stocks generally move together or stocks of all auto manufacturers move together. It is always a good idea to invest in stocks that don’t move together so that when one stock is down, the other is protecting your investment. This smallcase uses a quantitative methodology that decides the weights of the stocks in such a manner that diversification is maximized.
Dividend – Smart Beta
Screening criteria: Generally, retail investors overlook the dividend returns generated by a stock before investing. But in the long-term, dividend returns become very important and significant. The Dividend – Smart Beta smallcase selects high dividend yield companies from the top 150 market cap companies that have consistently increased their dividends over the last 5 years.
Quantitative weighting scheme: Just like the Smart Beta – Growth smallcase, this smallcase also uses a minimum volatility weighting methodology. Volatility or risk measures the magnitude of fluctuations in the investment value. Lower the volatility, lesser the fluctuations and smoother your investment journey. The risk that the portfolio could be down when you suddenly want to exit is minimized. The quantitative method decides the weights of the stocks in the smallcase to minimize the overall risk and volatility.