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Smart Beta a respite for investors in times of volatility

In the recent years, there is an increasing number of passive investment products to capture the potential benefits of factor investing (also referred to as “Smart Beta”) as well as the transparency and cost effectiveness of passive investing.

December 02, 2016 / 08:49 PM IST
The year 2016 has been an unpredictable year on many fronts, whether it was Leicester City FC winning the Premier League, the Brexit or the US Elections. Closer to home, “demonetisation” & GST are fundamentally altering target portfolios of fund managers. Active institutional fund managers have the benefit of professionally run research teams. The question is, therefore, how do individual investors churn their portfolios in times of such volatility.

Many active portfolio managers have been adopting risk factors to achieve portfolio diversification and deliver excess returns. These common risk factors include size, dividend, volatility, momentum, quality and value. In the recent years, there is an increasing number of passive investment products to capture the potential benefits of factor investing (also referred to as “Smart Beta”) as well as the transparency and cost effectiveness of passive investing.

We recently published a “Factor Risk Premia in the Indian Market” to study the risk-return characteristics of common risk-factors in the Indian equity market. The research analyzed four common equity risk factors including low volatility, risk-adjusted momentum, quality, and value based on the S&P BSE LargeMidCap universe between September 30, 2005 and April 30, 2016. Using monthly return of the S&P BSE LargeMidCap index to define up and down market, we summarized performance of different factors under these two market conditions.

The low volatility portfolio delivered significant excess return in the overall studied period and the excess return is more pronounced during the down market. The quality portfolio constructed using a combined score on return on equity (ROE), balance sheet accruals ratio and the financial leverage ratio, demonstrates similar defensive characteristic as seen in the low volatility portfolio. In contrast, the value portfolio constructed using book-to-price, earnings-to-price, and sales-to-price ratios tended to outperform during up markets but significantly underperformed in down markets. The risk-adjusted momentum portfolio did not deliver significant excess returns in the overall studied period however significantly outperformed the benchmark during down market.

The analysis shows different risk factors in the Indian equity market had distinct characteristics, therefore they can be used for implementation of active investment views. Moreover, blending risk factors with low return correlation may also provide portfolio diversification to mitigate portfolio risk.

Utkarsh Agrawal, Associate Director, Global Research & Design, S&P BSE Indices
first published: Dec 2, 2016 08:49 pm

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