A smart beta investment strategy is one in which a stock index is built with specific rules instead of a simple market cap based allocation. The nifty strategy indices are examples of a smart beta investment strategy. In a series of posts, I had covered several of these indices including a rolling a returns tool which can be used to measure the consistent of outperformance of mutual funds with respect to these strategy indices.
A smart beta ETF or index fund will give many active mutual funds a run for their money. Not all of them though.
In this post, I would like to introduce the Nifty High Beta 50 and discuss the reasons why it has performed terribly! Hence, high beta = unsmart beta.
Beta is a measure of relative volatility with respect to an index, as opposed to the standard deviation which is a measure of absolute volatility.
The Nifty High Beta 50 is the cousin of the Nifty Low Volatility 50.
The Low volatility 50 is selected from the top 300 companies (arranged by the free-float market cap) and by choosing the ones with the lowest standard deviation of daily returns (volatility).
The High Beta 50 uses the same shortlisting criterion and chooses the 50 stocks that have the highest beta using last 1Y trailing returns.
Wait, what exactly is beta? We shall get to it in a moment. Let us first look at the relative performance of the index.
This is a comparison of the High beta 50 with the low volatility 50 and the alpha 50. The alpha 50, as the name suggests are the 50 stocks with the highest alha wrt the Nifty.
Notice how badly the High Beta 50 has done. The Alpah 50 has outperformed the low volatility index during a bull run, but struggles during a sideway market.
In order to understand this behaviour, we must understand more about alpha and beta.
An investor requires to be compensated for the risk of holding a stock. The minimum compensation is referred to as the cost of equity.
This can be defined in the following way.
Relative volatility of a stock wrt market index = beta.
A stock with a beta of 1.1 is 10% more volatile than the index and a stock with a beat of 0.9 is 10% less volatile than the index.
Index return = Ir
Cost of equity = CoE
CoE = Rfr +Beta(Ir-Rfr)
Beta = (CoE-Rfr)/(Ir-Rfr)
This is an alternative definition of the Beta (according to the Captial Asset Pricing Model which has its own limitations).
High beta implies a high cost of equity. Or an unattractive stock.
If Rs = stock return, then
Alpha = Rs-CoE –> Excess returns above minimum expectation.
A stock which is more volatile than an index will exhibit a high beta. This could, in turn, increase the cost of equity and lower the alpha.
This is probably the key reason why the High Beta 50 underperforms the Alpha 50.
Since inception (via backtesting) the Alpha 50 has a beta of 0.96 wrt the Nifty. This means that the Alpha 50 has been 4% less volatile (for the period considered).
For the same period (from 31st Dec. 2003), the High Beta 50 has a beat of 1.32 wrt the Nify – a higher volatility of 32%!
Again for the same period, the low volatility 50 has a beta of 0.71 – lower volatility of 29%.
Will low volatility always work?
That depends on our definition of ‘work’. If the aim is to passively beat the Nifty then the answer is probably yes.
For volatile stocks, much of the gains made when they move up are erased when they fall. This is where a low volatile stock can score.
However, low volatility does not always mean high returns at all times. It only means a better risk-adjusted returns. A combination of alpha + low-volatility maybe better for those who take on a little more risk.