Factor / Smart Beta Investing
Before we deep dive in to Smart beta investing, let us re-light traditional forms of investing
Beta Investing
The term "beta" is simply a measure of a stock's sensitivity to the movement of the stock market. The beta of the Index is expressed as 1. An investment in an Index Fund or ETF typically carries a beta of 1.
Alpha Investing
An investment in Active Fund is primarily carried out with the objective of outperforming the index. Investors hold a view that the fund mangers will be able to identify Sectors and Stocks that are likely to outperform the benchmark and thereby deliver outperformance relative to the index.
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“A similarity between Beta and Alpha investing is that both are based on “capitalization-weighted” form of investing schools. 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”.
This limits diversification and that the biggest advantage of Smart Beta Investing
Factor Investing (Smart Beta)
The Smart Beta Investing approach was brought to lightin the Modern Portfolio Theory (MPT) by American economist Harry Markowitz. MPT, at its core, provides ways to develop a portfolio that is diversified in an optimal way. Further, the Smart Beta Investing is considered as 3rd Pillar of Investing alongside Active and Passive form of investing.
The primary objective of the approach is to acquire one of 4 things (or a combination of them):
Real diversification, as it doesn’t follow Market Capitalisation weighted form of Investing
Alpha
Low cost compared to Active Funds
Scientific and Disciplined
The Smart Beta is an investment strategy in which securities are chosen based on certaincharacteristics with the goal of achieving excess returns over benchmark. In particular, Equity factor investing forgoes traditional analysis of companies and stocks in favor of a systematicapproach to evaluating companies. Companies are assessed on how attractive they are based on oneor more factors, and then ranked against other firms. Higher ranked companies indicate a greateropportunity for “Outperformance”.
Factors are of various types like Volatility, Value, Quality, Momentum, Growth, Alpha etc.
Value
Momentum
Size
Quality
Volatility
Dividend Yield
Growth
Value
The value factor is based on the idea that undervalued stocks (with low price-to-earnings ratios or other fundamental indicators) tend to outperform overvalued stocks over time.
Momentum
The momentum factor is based on the observation that securities that have performed well in the recent past tend to continue performing well, while those that have performed poorly continue to underperform.
Size
The size factor suggests that smaller companies tend to outperform larger ones over the long term. This is known as the small-cap premium.
Quality
The quality factor emphasizes companies with strong fundamentals, such as high profitability, low debt, and stable earnings. Quality stocks are believed to offer more stability and resilience during market downturns.
Volatility
Low-volatility or minimum volatility factor focuses on stocks with lower historical price volatility. These stocks are expected to provide a smoother ride with potentially less downside risk.
Dividend Yield
The dividend yield factor involves investing in stocks with relatively high dividend yields. These stocks often provide income and may be less sensitive to market fluctuations.
Growth
The growth factor emphasizes companies with high expected future growth rates in earnings. These companies often reinvest their earnings to fuel growth.
It’s important to note that the performance of factors can vary over time, and factors can go through periods of underperformance. Furthermore, the choice of factors depends on an investor’s specific goals and risk tolerance. Factor investing provides an opportunity to create customized portfolios that align with individual investment objectives while being aware of the unique risks and potential rewards associated with each factor.