Understanding smart beta funds and how they can boost index returns

Beta measures the volatility, or systemic risk, of a security or portfolio compared to the market. For instance, a company operating in a cyclical industry may carry some specific risks. The company’s stock, therefore, may be more volatile than the overall markets and hence have a high beta. The same may be said of a portfolio. If the portfolio exhibits higher volatility than the market, it may be considered to have high beta, and vice versa.

The reference point for a security or a portfolio’s beta is the market. The market should ideally be well-diversified with various securities. and would have a beta of 1.

Stocks having more risks than the market would have a beta higher than 1, and those having less risk would have a beta lower than 1.

Alpha, on the other hand, refers to the additional return a fund manager or a portfolio generates, given the assumed risks or beta.

Smart beta

Alpha is generally used in the context of actively managed funds, where the fund attempts to generate excess return over the markets. Extending the concept of alpha to passive funds, we have a variation of beta, called Smart Beta.

Exchange-traded funds (ETFs) or index funds replicate an index and don’t aim to generate excess returns. However, smart beta involves indices designed to potentially outperform the market.

In general, investors refer to indices like Sensex, Nifty, midcap, and smallcap indices as markets. These indices have two things in common:

– They would be diversified across sectors and themes. For example, the indices would consist of stocks from financial services, IT, oil & gas, and others.

The weights of stocks would be based on their market capitalization, which means that large stocks with higher market capitalization would have a higher weight in the index, whereas another stock with lower market capitalization would have a lower weight.

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In the Nifty 50 Index, the top stock has a weight of 11%, whereas the last stock has a weight of less than 0.5%. Similar phenomena occur in midcap and smallcap indices.

Any variation on these indices that would work differently and could potentially generate better returns from time to time may be considered ‘smart beta’ strategies. The NSE and BSE aptly classify such indices as ‘strategy’ indices. These indices apply specific rules to broad market indices like Sensex, Nifty Midcap, Nifty 500, etc., which could potentially outperform the parent indices.

Smart beta funds

Passive funds that replicate or track strategy or smart beta indices are called smart beta funds. Several such strategy indices are available in the Indian markets. Value, growth, quality, momentum, dividend opportunities, alpha, low volatility, and equal weight, are some of the popular strategy indices.

These strategies may be applied to one or multiple areas of the market, allowing for numerous combinations of strategies. For example, the concept of ‘value’ may be applied to Nifty and the midcap segment, resulting in two different indices/funds following the ‘value’ strategy. Likewise, multiple factors could also be combined to create a specific strategy. For instance, alpha and low volatility factors could be combined to create a strategy called ‘alpha low volatility’.

Equal weight as a strategy, for example, could result in very different risk-return outcomes when compared to the parent indices.

Also Read: Active vs index funds: Which strategy protects your investments better?

An investor may want to make a broad-based investment and choose a fund based on the Nifty 500 index. Since this is a broad-market index, constructed based on market capitalisation, the top 100 stocks, which are all largecap stocks, account for nearly 73% of the portfolio. In other words, though the investor wanted to broad-base her investments, she would have ended up investing predominantly in large caps.

On the other hand, if investments were made equally to all the 500 stocks, the investor’s exposure would be 20% in large caps (the top 100 out of 500 stocks), 30% in midcaps (next 150 stocks) and 50% in smallcaps (the remaining 250 stocks). This approach would have resulted in far higher diversification than the parent index, an approach that the investor may have sought when she attempted to invest in the broader markets. This strategy has generated 56% returns in the last one year against 39% of Nifty 500 (as of 31, July 2024).

Smart beta funds may work differently from commonly known broad market indices, depending on the type and nature of the underlying indices.

Arun Sundaresan is head-ETF of Nippon India Mutual Fund