Smart Beta For Volatile Times
In the equity market not everything goes up in tandem and comes down in that order. There are themes and factors that play differently in different periods of the business cycle, market cycle and investor sentiment. The following report provides some insights
In the last one year, against all the expectation and prediction, the equity market globally has witnessed one of the best run in years. The last time we saw such a phenomenal return from equity in India in a one year period was almost 11 years back in the years 2009 and 2010 just after the global financial crisis. The graph of rolling one year returns shows the one year rolling return of the Sensex since 1998. We see that only in four occasions in the last 23 years the equity market at a broader level has generated such higher returns.
The graph also highlights how after such a spectacular return the market tends to generate lower returns going ahead. For example, after generating annual return in excess of 100 per cent in 2009 and 2010, the return generated by the Sensex in 2011 and part of 2012 was negative.
The reason for such a negative return is that as the market moves vertically, many cases of speculative excess are built up. There is inundation of ideas from various social websites and investors are naive enough to act on them. It takes some time to clear this excess through time correction or price correction.
Nonetheless, during such time or price correction the activity might shift somewhere else. In the equity market not everything goes up in tandem and comes down in that order. There are themes and factors that play differently in different periods of the business cycle, market cycle and investor sentiment. For example, when the business cycle is in an expansion stage and investor sentiment is bullish, ‘value’ and ‘small-cap’ funds tend to perform better. The same phenomenon has been visible in the latest rally where we saw ‘value’ stocks becoming the new ‘momentum’ stocks. All the mutual funds dedicated to the value theme, after underperforming for years, have outperformed the market recently.
Many of the funds dedicated to such a theme have seen their net asset value (NAV) double in the last one year. On an average, these funds generated returns of roughly 85 per cent compared to around 70 per cent in case of large-cap-dedicated funds. The biggest question in the minds of many investors is about which theme or factor is going to play out in the next one year or three-year period. An answer to this question will help them to position their portfolio accordingly. Before delving deep into those themes let us first understand what the different themes are, when they outperform the other themes and how you can take exposure to such themes. The theme of value and momentum is also known as factors.
Factor Investment and Smart Beta
Various studies by leading finance academics has shown that returns by passively managed funds are likely to perform better than the actively managed funds in the long run due to their lower cost structure. Smart beta investment is also a variant of passively managed funds with a twist that they invest in companies forming part of indices built not on market capitalisation but based on certain factors such as value, momentum, low volatility, size, etc. Hence, smart beta is a general term for a multitude of investment strategies, which tend to have the following in common: they use mechanical index construction rules that differ from traditional market capitalisation based indices and they attempt to capture systematic factors or market inefficiencies in a straightforward and transparent manner which involve no human judgment or subjectivity once they have been put in place.
Globally, smart beta has become extremely popular, both as an alternative to passive market-weighted indexing and traditional active investing. According to research firm Morningstar, by the end of June 2020, 632 smart beta ETFs with about USD 869.7 billion in assets existed, up from about USD 400 billion in assets six years ago. Smart beta is a simple and transparent form of factor investing, which is generally available to investors at low cost. In India it is still at a nascent stage and ETF as a category form less than 10 per cent of the total AUM of domestic mutual funds. Majority of the ETF AUM is concentrated towards Nifty and Sensex and that is primarily driven by the government’s effort.
Over the past few years, the Employees’ Provident Fund Organisation (EPFO) has invested as much as 15 per cent of its incremental inflows into ETFs. The assets under management (AUM) in ETFs in India has surged from around Rs14,600 crore in February 2014 to Rs2.7 lakh crore in February 2021—a nineteen-fold growth over the past seven years. Out of this, smart beta ETFs form less than 10 per cent of the domestic mutual fund AUM and there are only a few smart indices that they trace. Following are some of the indices that smart beta ETFs track currently in India:
✓Nifty NV 20: This index takes the 20 most ‘value-oriented’ companies in the Nifty, selected on the basis of price-to-earnings, price-to-book, and other value factors.
✓ Nifty Low Volatility 30: The Nifty 100 Low Volatility 30 index tracks the performance of 30 stocks in Nifty 100 with the lowest volatility over the past one year.
✓ Nifty Quality: This index consists of 30 companies which are selected based on low gearing, high return on equity and profit growth. Stocks are selected based on quality score which is calculated on the basis of return on equity (ROE), debt equity ratio (DE) and average change in EPS.
✓ Nifty Quality Low Volatility 30: This index tracks 30 stocks selected from the Nifty 100 and the Nifty Mid-Cap 50 on the basis of quality and low volatility.
✓ Nifty Equal Weight Index: This index assigns equal weights to all Nifty stocks rather than weights based on market capitalisation.
✓ Bharat 22 and CPSE Index: These were set up to meet disinvestment targets and are either public sector-dominated or have a significant public sector component.
Performance of Smart Indices
Most of the funds or ETFs in this category are yet to complete five years. Hence, we studied the performance of the smart indices that these funds are slated to imitate. The performance of these indices is quite encouraging. We took data of these indices from the year 2010 and compared it with the Nifty 50 to gauge its performance. Rolling returns were calculated for three years and were annualised. This means that the first return was calculated for a date between the start of 2010 and end of 2013 which was then annualised. This process was done for every trading date between the start of 2010 and end of March 2017. In this process we analysed 2,401 data points and found that on an average smart indices have outperformed Nifty 50. The graph below shows the rolling returns of these indices since the start of 2013. Most of the indices have outperformed the Nifty. At this point many of you would be thinking about the risk of these indices.
Against common wisdom, these themes also seem to have lower risk in our period of study. The common perception is that while investing in a pure passive fund, like Nifty 50 or Sensex, you invest in a diversified basket of stocks with all the themes and factors embedded into them and hence lower risk. In factor-based investing, however, once you apply filters and reduce the number of stocks, a couple of things happen. One, the level of diversification comes down and the portfolio risk goes up. Nevertheless, in our study we saw that these themes have done well in our back tests run on historical data. The measure we used to assess the risk is drawdown. A drawdown measures the decline in your investment from its peak-to-trough during a specific period. The graph below again shows that these indices trump over Nifty 50. We see that Nifty 50 has the highest drawdown while Nifty Low Volatility has the lowest drawdown.
There is no guarantee that these conditions will continue; however, we do not find any reasons that it will change even in the future as our study has covered more than 10 years and has seen the entire market cycle, business cycle and investor sentiment that drives the performance of indices.
Factors for Selection
One theme that is clearly dominating the market is volatility. Recently we are witnessing the frontline equity index such as Nifty 50 falling by more than 200 points on one day to rise by more than 300 points the next day. The heightened volatility is owing to factors such as lockdown fears, hardening bond yields and rising inflation. Therefore, allocating part of your portfolio towards themes that tend to outperform during volatile times or when the overall market falls will add cushion to your portfolio from the potential downside.
To understand which factors we can count now, we studied the calendar returns of these themes and compared them with Nifty 50. In the last 11 years ending 2020, there were two instances (2011, 2015) when Nifty 50 gave negative return. In both these years, low volatility and quality outperformed consistently. The graph below shows the calendar year performance of these indices.
"Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market."
- Warren Buffett
Another interesting fact that emerges from the above calendar year return analysis is that quality tends to outperform other themes after a good run by Nifty 50. In years 2012, 2014 and 2017 Nifty 50 generated return in excess of 20 per cent and in the subsequent years 2013, 2015 and 2018, the quality theme generated superior returns.
Even in the last financial year, Nifty 50 has generated returns in excess of 70 per cent – the best since FY10. The above analysis clearly shows that it will be a good idea to allocate part of your portfolio into these smart beta names. The theme that we believe is good for the next couple of years is that of quality and low volatility. This is because these themes play out well during a volatile market. Following is the list of some of smart beta ETFs available now.
The graph shows that the value theme has played out last year and may underperform other themes going ahead. It has generated more than 35 per cent since September 2020.
Therefore, our suggestion for investors is to go for ETFs dedicated to low volatility and quality. You could improve your overall portfolio by including exposure to quality and low volatility ETFs, which are thought to offer downside protection and have exhibited slightly smaller drawdown. However, investors should note that these are ETFs and you need to have a dematerialisation account to buy these ETFs. Beside, liquidity is poor in many ETFs, pushing up the cost of buying and selling although this is remedied to some extent by investing in fund-of-funds holding the ETF concerned. Also these themes should ideally be part of your satellite portfolio and not the core as not all the themes play all the time depending upon the market and business cycle. You should not allocate more than 20 per cent of your portfolio towards such themes. The financial markets have long been characterised by a boom-bust cycle. While timing the market rarely works, shifting asset allocations can help reduce risk without the opportunity cost of going to cash too early. Smart beta funds can help you to diversify your overall portfolio and potentially curb some stock market volatility. It helps you to hedge against risks during frothy market conditions. With a focus on low volatility and quality factors, investors can insulate their portfolios from secular declines and minimise risk factors.