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When you go for a job interview, you are evaluated on certain criteria. Depending on the requirement, it could be operational capabilities or work experience or leadership values or even the ability to think out-of-the-box. The factors that the interviewer considers will be those that the organization needs for a specific role.

Apply the same analogy to investing. Certain “factors” are identified as potential drivers of return. The most popular factors being value, momentum, quality, alpha, and low or minimum volatility. This, in a nutshell, is what is known as factor-based investing.

Factor investing straddles the line between active and passive investing, a middle ground so to speak. Its starting point is a traditional passive index which is later filtered basis certain factors. The result of this is a passive investment instrument with elements of active fund management approach for the smart beta index.

By diverging from the benchmark, using a rules-based methodology, factor investing has the potential to improve performance relative to a traditional index.

Factor Investing: A building block of Smart Beta ETF

When factor investing is applied to Exchange Traded Funds (ETFs), it is known as Smart Beta ETFs. These funds attempt to optimise the risk-reward return of a traditional index fund. The beta of a stock/fund is a measurement of its volatility of returns relative to the benchmark. Beta of 1 signifies that it is as volatile as the market, greater than or lesser than 1 signifies more or less volatility than the market, respectively. To understand how such offerings are constructed and can be a fit in a portfolio, let us look at three examples.
  Index:  The Nifty50 Value 20 Index
  Details: The index is designed to reflect the behaviour and performance of a diversified portfolio of 20 value companies forming a part of Nifty 50 Index.
  Factor: Value
  Portfolio: 20 companies are selected on the basis of Return on Capital Employed (ROCE), Price-Earnings (PE), Price to Book Value (PB) and Dividend yield (DY).

If you are looking for a value bent in your portfolio but wishes to stay with reliable bluechips, then an offering based on this index helps meet the need.

  Index: The Nifty100 Low Volatility 30 index
  Details:  The index comprises of 30 stocks from the Nifty 100 universe with the lowest volatility in last one year.
  Factor: Low Volatility
  Portfolio: Securities in the Nifty 100 index are assigned weights based on the volatility values. Thereafter, security with the lowest volatility is selected to be a part of the portfolio.

If volatility in the market unnerves you and steadiness is what you crave, this is a good option. Alternately, if major portion of your portfolio is tilted towards mid and small caps, which by nature are volatile, an offering based on low volatility index can help balance volatility in your portfolio.

  Index: The Nifty200 Quality 30 Index
  Details: Covers 30 companies which have durable business models resulting in sustained growth.
  Factor: Quality
  Portfolio: The 30 stocks are filtered from the Nifty 200 universe, post filtering through parameters such as Return on Equity (RoE), Debt to Equity ratio and variability in Earnings Per Share (EPS) over the previous five years.

Investors can consider opting for a quality based offering when valuations are stretched but is looking to invest into quality companies.

Why Consider Smart Beta ETFs?

If your portfolio only has actively managed funds and its tilted towards a certain style of investing, it would make sense to invest in a smart beta fund to act as a counterbalance and negate style oriented risks. In a smart beta offering, factors are the building blocks and there is no element of human bias as it is completely rules based. Such a passive offering would complement the active funds in your arsenal. As explained by the examples mentioned, there are a variety of options to choose from.

Since they are passively managed and replicate the performance of a specific index, they tend to have lower expense ratio. Also, they provide solutions in a transparent and cost-effective manner with the potential for enhanced returns, which will help solidify your equity portfolio.

The autthor is Principal- Investment Strategy, ICICI Prudential AMC. Views are personal.