Smarter Investment in Beta

Smarter Investment in Beta

In recent years, mutual fund investors and stock market investors have started to invest in so-called smart beta investment strategies. As with any investment choice, Lets understand the concepts behind a particular strategy before investing & examine the concepts behind the recent popularity of smart beta strategies which are deployed in these types of mutual funds.

The performance of the stock market, whether as a whole or as different segments, is measured by stock market indexes. For example, the Nifty index is a widely used measure of overall performance of the Indian stock market. As its name suggests, this index measures the daily changes among large Indian companies, based on their market capitalization. 

The term “Beta” is simply a measure of a stock’s sensitivity to the movement of the overall stock market. The beta of the Nifty is expressed as 1.0. The beta of an individual stock is based on how it performs in relation to the index’s beta. A stock with a beta of 1.0 indicates that it moves in tandem with the Nifty.

If a stock’s performance has historically been more volatile than the market as a whole, its beta will be higher than 1.0. For example, a stock with a beta of 1.1 is 10% more volatile than the market. So if the Nifty rises 10%, a stock with a beta of 1.1 is expected to rise by 11%. Of course, beta works both ways. If the Nifty falls 10%, a stock with a beta of 1.1 is expected to fall by 11%. Generally, the higher a stock’s beta, the more volatile it is; this is where the mutual fund opportunities exist.

While a stock’s beta measures its volatility, it is important to note that it does not necessarily predict direction. A stock that performs 50% worse than the Nifty in a down market and a stock that performs 50% better than the Nifty in an up market will each have a high beta. Therefore, beta is best used for finding companies that tend to track the movements of the Nifty (i.e., with betas closer to 1.0).

If you have a mutual fund portfolioand are easily rattled by market volatility, you may want to seek out mutual fund investments with a lower beta. Conversely, if you are seeking potentially higher returns in exchange for higher risk, higher beta mutual funds might generally be a good match for riskier investment in your portfolio and to capitalize on the advantages of these high beta mutual funds that use market movements to benefit your mutual fund portfolio.

Alpha vs beta

“Alpha” is another common term you’ll see when researching investments, particularly mutual funds. Unlike beta, which simply measures volatility, alpha measures a mutual fund portfolio manager’s ability or skill to outperform a market index. Alpha is a measure of the difference between a mutual fund portfolio’s actual returns and its expected performance, given its level of risk as measured by beta.

For example, if a mutual fund returned 10% in a year in which the Nifty rose only 5%, that fund would have a higher alpha. Conversely, if the mutual fund gained 10% in a year when the Nifty rose 15%, it would earn a lower alpha. The baseline measure for alpha is zero, which would indicate an investment performed exactly in line with its benchmark index.

Generally, if you were investing in a mutual fund or other type of managed investment product such as a portfolio managed service, you would seek out managers with a higher alpha to get the maximum benefits in mutual funds. Keep in mind that both alpha and beta are based on historical data of a mutual fund. As every mutual fund investment prospectus warns, past performance is no guarantee of future returns.

Next is “Smart beta”

As explained above these are, a fund’s or stock’s sensitivity to movements in the broader nifty market is measured by its beta. By understanding a fund’s or stock’s beta, investors can theoretically build a mutual fund portfolio that matches their risk tolerance.

In recent years, however, some of the mutual funds in India offer a new approach to investing called smart beta funds which have started to gain traction among mutual fund investors. Smart beta refers to a sophisticated enhanced indexing strategy that seeks to exploit certain performance factors in an attempt to outperform a benchmark index such as Nifty. In this sense, smart beta differs fundamentally from a traditional normal passive indexing strategy.

Smart beta strategies also slightly differ from normal actively managed mutual funds, in which a fund manager chooses among individual stocks or sectors in an effort to beat a benchmark index. Smart beta strategies seek to enhance returns, improve diversification, and reduce risk by funds investing in customized indexes or ETFs based on one or more predetermined “factors.” i.e. Momentum, Growth, Value etc. They ultimate aim to outperform, or have less risk than, traditional capitalization-weighted benchmarks in India.

Most traditional mutual funds and index funds and ETFs are “capitalization-weighted.” This means that the individual stocks within the index are based on each stock’s total market capitalization. Stocks with higher market capitalizations are weighted more heavily than stocks with lower market capitalizations. As a result, it’s possible for a handful of highly valued stocks to represent a large percentage of the index’s total value.

The advantage that these mutual funds exploit is that relying solely on market exposure to determine a stock’s or fund’s performance relative to its index, smart beta strategies allocate and rebalance portfolio holdings by relying on one or more factors. A factor is an attribute that might help to drive risk or returns, such as Quality or Size.

For example, stocks of companies in India that generate superior profits, strong balance sheets, low debt and stable cash flows are considered high quality, and tend to outperform the market over time.  Similarly, small cap funds, stocks have historically outperformed large cap funds, stocks, although leadership can shift in shorter periods. Many factors are not highly correlated with one another, and different factors may perform well at different times depending on market situations.

An investment strategy that blends components of active and passive mutual fund investing appeals to you, then you might want to consider investing in smart beta strategies. Before investing, be sure review the mutual fund’s scheme carefully to ensure you understand the risks fully.