In 3 days from today, people across the world will celebrate the birth of Lord Buddha which happened about 2,642 years ago in Lumbini, Nepal. In his search for truth & the meaning of life, Prince Siddharth gave up his royal comfort & explored the many different facets that life has to offer, including that of an ascetic/yogi with no worldly possessions.
Lord Buddha came to the conclusion that an individual who seeks enlightenment needs to avoid both the extremes of self-indulgence and self-mortification. Since he advocated avoiding both the ends of the pain/pleasure spectrum, the path advocated by him came to be known as The Middle Path - or the path of moderation - and this is probably the most popular of all the Buddhist teachings.
While the functionings of Dalal Street & the world of investments might be a far-cry from most Buddhist teachings, one financial concept called Smart Beta, which has increasingly gained global prominence in the last 5-10 years, actually embraces the middle-path philosophy.
As you may know, one of the most debated topics in investing is “active vs. passive”. In case you aren’t aware, here’s a simple gist in 5 points on where this debate stands today:
Active investing involves decision-making based on subjective judgments of individuals (whether it’s a retail investor or a fund manager). Data shows that on average, most active fund managers across the globe fail to beat their respective benchmark index
Passive investing follows a rules-based or systematic strategy - the portfolio is constructed using a pre-defined set of rules (e.g. buy stock when P/E is less than 10, sell when P/E exceeds 25). There is no subjectivity involved. The most common form of passive is indexing, where the investor just buys the market index (e.g. investing in the Nifty-50 index fund/ETF)
- Fees is argued to be the main return differentiator between the two styles - active investing is costlier than the two, which directly reduces net returns and performance
- Passive investing has become super popular across the globe in recent years due to the underperformance of active fund managers
- Interestingly, one of the biggest proponents of passive investing is Warren Buffett, who is arguably also the world’s most famous active investor
Smart Beta is seen as a midway between active & passive investing since it employs both - it’s active in its construction since it deviates from the traditional index, yet passive as it doesn’t rely on any subjective calls from individuals, instead following a predefined rules-based methodology. And it’s also low-cost (though a bit more than passive index funds).
Traditional indices like Nifty-50 & Sensex are market-cap weighted - i.e., the higher the market-cap of a stock, the higher will be its weightage in the index.
Smart Beta strategies also start with the same stock universe, but these stocks are then weighted based on factors like volatility, growth, value, dividends, etc. - rather than the market-cap/size of the company
For example, in Low-Volatility Smart Beta strategies, stocks that are least volatile have the highest weightage in the index. Or, in case of Smart Beta strategies focused on Value factor, the weighting scheme is based on things like P/B ratio & similar indicators of value. In fact, even if one takes the Nifty-50 index and equally weights all the stocks (instead of market-cap weighting) - this would be a simple example of a smart beta strategy.