Globally, a growing number of Exchange Traded Funds, or ETFs, straddle the line between active and passive, offering investors a dizzying array of increasingly complex choices. The monikers describing the intersection of active and passive investing are multifarious - smart beta, advanced beta, alternative beta, enhanced indexes, strategy indices, and quantamental indexes.
At Morningstar, we refer to smart beta as strategic beta.
Strategic beta products represent a middle ground on the active-to-passive spectrum—they deviate from a traditional, strictly passive market portfolio, but do so in a rules-based, transparent, and relatively low-cost manner.
We concur that strategic beta may not roll off the tongue as easily as smart beta, but we believe it is a more accurate descriptor and does away with the positive connotations that may be inferred by the "smart" in smart beta. Not all strategies included in this arena are smart, per se.
The term strategic is meant to draw attention to the fact that the benchmark indexes underlying the products in this space are designed with a strategic objective in mind. These objectives primarily include attempting to improve performance relative to a traditional market-capitalization-weighted index or altering the level of risk relative to a standard benchmark.
The Morningstar Strategic Beta Guide will provide you with more information on the subject.
Now in India, SBI Mutual Fund has come out with such an offering termed SBI-ETF Quality, a smart-beta offering that tracks the Nifty200 Quality 30 index. This index fits Morningstar’s definition of strategic beta.
Here’s what you need to know about the NIFTY200 Quality 30 index:
- The index derives its 30 stocks from its parent NIFTY 200 index. These 30 stocks are determined to be those with higher profitability, lower leverage and more stable earnings.
- The 30 stocks are quantitatively selected based on their ‘quality’ scores which are determined based on three parameters analysed over the past 5 years:
- Return on Equity (ROE): A measure of the profitability of a business in relation to its equity
- Financial leverage (Debt/Equity Ratio): The amount of debt a company uses over its common equity. An excessive amount increases the risk of failure.
- Earnings Per Share (EPS): This indicates a company’s ability to produce net profits for common shareholders.
- The weight of each stock in the index is based on the combination of stock’s quality score and its free float market capitalization.
- The index is rebalanced semi-annually.
So how do such funds fit into a portfolio? Are they more focused on risk mitigation rather than alpha generation? Should they be associated more for downside protection than alpha generation?
Ben Johnson,
director of passive funds research at
Morningstar, answers that query.
These funds may seek to improve returns or alter (either increase or decrease) the risk profile of their portfolios relative to a standard market-cap weighted benchmark. Many attempt to deliver the best of both worlds, simultaneously enhancing returns and reducing risk.
These are, for all intents and purposes, active strategies. As such, I think its helpful to think of most of them as being alpha-seeking—much like active strategies. This, I would hope, would prompt investors to approach them with a degree of skepticism and to leave no stone unturned when doing their due diligence.
