The history of stock investing has been mostly dominated by “active” strategies that have aimed to beat the market by generating higher returns than the benchmark index. Over the years, different investors and fund managers have explored different styles like value, momentum, and growth in an attempt to generate “alpha”.

Active investors across the globe have not been able to beat the market consistently, due to the high fees along with the inherent uncertainty.

This has led to the growth of “passive investing”, especially in the last decade. This follows a rules-based or systematic strategy. The portfolio is constructed using a pre-defined set of rules. The most common form of passive is indexing, where the strategy rules are identical to that of the benchmark index (for example investing in the Nifty-50 index via an index fund or ETF).

The main issue with indexing is that by definition, investors will not get superior returns or “alpha”. Since you are investing in a fund that tracks the index, net of the fund expenses, your returns will always be lower than the benchmark index.

This is why “active” versus “passive” has been a raging debate in the investment world in the past few years. Is active management worth the costs? Or are investors better off getting returns slightly lower than the benchmark index?

Well, what if you could invest in a strategy that gives you the best of both? Smart Beta is a mix of active and passive investing since it employs both. It is active in construction since it deviates from the traditional index, yet passive as it does not rely on any subjective calls from individuals. And it’s low-cost, generally charging a bit more than index funds but less than active funds.

Traditional indices like Nifty-50 and Sensex are market-cap weighted, the higher the market cap of stock, the higher will be its weightage in the index. Smart Beta strategies, also known as“factor investing” aim to outperform the index by redesigning it.Rather than the market cap of a company, this strategy assigns stock weightage based on “factors” like volatility, growth, value, and dividends. For example, Low-Risk Smart Beta small case aims to outperform the large-cap index by giving higher weightage to large-cap stocks that are less volatile. It takes advantage of the “Low-Risk Anomaly”, which is the observation that less risky stocks (i.e. low volatility stocks) tend to generate superior risk-adjusted returns. Compared to the Nifty-100, this strategy delivers higher returns for similar levels of risk which is why it’s Sharpe ratio is 1.72 approx., 50 per cent higher than that of Nifty-100.

On the other hand, the Quality Smart Beta small case aims to outperform the large-cap index by giving higher weightage to quality companies. It uses fundamental criteria like Return on Equity (RoE), Debt-to-Equity (D/E), earnings variability, and accrual ratios to build a “quality score”, based on which the final portfolio is selected.

Smart Beta strategies have seen tremendous adoption globally in the last few years, with global AUM reaching $835 billion as of November 2019, based on data from ETFGI/ Nasdaq. While Smart Beta strategies are still relatively new in India, it has been rapidly attracting investments.

The NSE already has more than 10 indices that focus on Smart Beta factors, and AMCs have also launched products that are based on these. Currently, there are two mutual funds, seven ETFs, and three small cases (1 each on low-volatility, quality, and dividend factors) that are available for Indian investors to take this kind of exposure, which aims to beat the benchmark index.

The author is AVP Growth, smallcase Technologies