Beta measures the volatility or systematic risk of a security or portfolio compared to the market. For example, a company operating in a cyclical industry may take on certain idiosyncratic risks. Therefore, the company's stock may be more volatile than the overall markets and therefore have a high beta. The same can be said about a portfolio. If a portfolio exhibits greater volatility than the market, it may be considered to have a high beta, and vice versa.
The reference point for the beta of a security or portfolio is the market. Ideally, the market should be well-diversified with different securities and its beta should be 1.
Stocks that have more risk than the market will have a beta greater than 1, and those that have less risk will have a beta less than 1.
Alpha, on the other hand, refers to the excess return that a fund manager or portfolio generates based on the assumed risk or beta.
Smart Beta
Alpha is typically used in the context of actively managed funds, where the fund attempts to generate excess returns over the markets. Extending the concept of alpha Passive FundWe have a form of beta called smart beta.
Exchange-traded funds (ETFs) or index funds mimic indexes and do not aim to generate excess returns. Smart beta, however, involves indexes that are designed to potentially outperform the market.
Investors usually refer to indices such as Sensex, Nifty, Midcap and Smallcap as markets. These indices have two things in common:
– They will be diversified across different sectors and themes. For example, the indices will include stocks from financial services, IT, oil and gas and other sectors.
The weightage of the stocks will be based on their market capitalization, which means larger stocks with higher market capitalization will have a higher weightage in the index, while other stocks with lower market capitalization will have a lower weightage.
Also read: Dear Investor, you do not need to run mutual funds only on mutual funds.
The top stock in the Nifty 50 index has a weightage of 11%, while the weightage of the last stock is less than 0.5%. The same situation is seen in the midcap and smallcap indices.
Any variation in these indices that would act differently and deliver better returns over time can be considered a 'smart beta' strategy. NSE and BSE classify such indices as 'strategy' indices. These indices apply specific rules to broad market indices like Sensex, Nifty Midcap, Nifty 500, etc., which can potentially outperform the original indices.
Smart Beta Funds
Passive funds that mimic or track strategies or smart beta indices are called smart beta funds. There are several such strategy indices available in the Indian markets. Value, growth, quality, momentum, dividend opportunity, alpha, low volatility and equal weight are some of the popular strategy indices.
These strategies can be applied to one or multiple sectors of the market, allowing for multiple combinations of strategies. For example, the concept of 'value' can be applied to the Nifty and the midcap segment, resulting in two different indices/funds that follow the 'value' strategy. Similarly, multiple factors can also be combined to form a specific strategy. For example, alpha and low volatility factors can be combined to form a strategy called 'alpha low volatility'.
For example, equal weighting as a strategy can result in very different risk-return results than the basic indices.
Also read: Active vs. index funds: Which strategy better protects your investment?
An investor may want to invest on a broad basis and choose funds based on the Nifty 500 index. Since this is a broad market index, constructed on the basis of market capitalisation, the top 100 stocks, which are all largecap stocks, make up about 73% of the portfolio. In other words, although the investor wanted to broad-base his investments, he would have invested primarily in largecaps.
On the other hand, if all 500 stocks were invested equally, the investor would have 20% exposure to large caps (top 100 stocks out of 500), 30% to midcaps (next 150 stocks) and 50% to smallcaps (remaining 250 stocks). This approach would have resulted in far greater diversification than the original index, an approach that the investor would have adopted when attempting to invest in the broader markets. This strategy has delivered a return of 56% in the last one year as against Nifty 500's 39% (till 31 July 2024).
Smart beta funds may operate differently from commonly known broad market indices, depending on the type and nature of the underlying indices.
Arun Sundaresan is the ETF head of Nippon India Mutual Fund
