Decoding Investment Strategies

Decoding Investment Strategies: Active, Passive, and Smart Beta Investing Explained

In the world of finance, understanding different investment strategies is the key to generating optimal risk-adjusted returns. Choosing the right investment strategy can make a big difference to your financial growth.

Three common investment strategies are active investing, passive investing, and smart-beta investing. The debate about active investing vs. passive investing is a never-ending one. However, knowing about these strategies will help you make better decisions that support your financial goals.
 

Active Investing

What is Active Investment?

Fund managers take a hands-on approach in active investing, making specific decisions to beat the market indices. It is a dynamic strategy that requires frequent trading and analysis based on market conditions.

How Active Investing Works

Economic indicators, market movements, and analysis are all key components of active investing. Fund managers may aim to benefit from short-term price movements by trading shares frequently.

Advantages

  • Potential to Outperform: Skilled fund managers use their expertise and competency to generate high returns.
  • Flexibility: As the market changes and new opportunities arise active investors can adapt quickly.

Disadvantages

  • Discretion and Bias of Fund Manager: Active investing is highly dependent on the manager’s experience and judgement, both of which can be biassed.
  • Time and Expertise: Active investing requires continuous monitoring and in-depth market knowledge which can be time-consuming.
     

Passive Investing

What is Passive Investment?

Passive investing aims to replicate a specific index or benchmark. This approach involves investing in a broad market index or a subset of the market, aiming to replicate the market performance rather than trying to beat it. 

How Passive Investing Works?

Passive investors track a specific index. All the stocks included in the particular index, in the same weightage, are incorporated into the portfolio. 

Advantages

  • Simplicity: Passive strategies replicate an existing index so are easy and simple to understand and hence accessible to new investors.
  • Transparency: Passive investment simply replicates a specific index so investors know exactly what they are investing in and how the portfolio constituents are selected.

Disadvantages

  • Limited Flexibility: New opportunities or changes in the market can’t be easily adapted by passive investors.
  • Replicates Market Return: The goal of passive investing is to replicate the market return, not to beat it, which may not be suitable for some investors.
  • Large-cap bias: Disproportionate allocation of more funds to larger companies can potentially lead to missed opportunities in smaller, high-growth, and high-quality companies. As the below graph and table show, historically NIFTY 50 Equal weighted TRI has outperformed NIFTY 50 TRI over time. 

nifty50
 

  NIFTY 50 Equal Weight - TRI NIFTY 50 - TRI
Point-to-Point Returns (%) 14.88 13.37

 

  NIFTY 50 Equal Weight - TRI NIFTY 50 -TRI
10 Year Mean Rolling Return (%) 16.42 14.57
10 Year Median Rolling Return (%) 16.34 14.6


Source: CMIE, NJ’s Smart Beta Platform (in-house proprietary model of NJAMC). Data for the period 3rd November 1995 to 31st July 2024. Past performance may or may not be sustained in future and is not an indication of future return.
 

Smart Beta Investing

What is Smart Beta Investing?

Smart beta investing combines both passive and active strategies. The goal is to get higher returns, diversify investments, and lower risk by focusing on certain factors instead of just market capitalization.

How Smart Beta Investing Works?

Creating custom rule-based portfolios based on factors like value, size, volatility, and momentum is a key part of smart beta strategies. These approaches aim to be cost-efficient while harvesting the benefits of factor-based investing.

Advantages

  • Diversification: Stocks are selected based on various factors, which can reduce concentration risk. 
  • Systematic Approach: Focuses on a rule-based strategy that reduces emotional and behavioural biases. 
  • Potential of Higher Returns: Smart beta strategies can potentially outperform traditional market-cap-weighted indices by tailoring the portfolio based on certain factors.

Disadvantages

  • Need of Quality Data for Back-testing: Acquiring and maintaining high-quality data can be challenging in terms of cost and accessibility. Without this long-term data, back-testing may fail to capture how a strategy performs. At NJ AMC, we partner with leading data companies, and our robust processes ensure that we procure and maintain high-quality data. 
  • Performance Varies: Depending on the parameters chosen and the market conditions smart beta funds can perform differently. However, by strategically combining all the factors in the investment portfolio, an investor can overcome the challenges of factor cyclicity.

internal-research

Source: Internal research, Bloomberg, CMIE, National Stock Exchange. Calculations are for the period 30th September 2006 to 31st July 2024. The Years 2006 and 2024 does not represent complete Calender Year. NJ Traditional Value Model, NJ Enhanced Value Model, NJ Quality+ Model, NJ Momentum+ Model, NJ Low Volatility+ Model and NJ Multi-Factor+ Model are proprietary methodologies developed by NJ Asset Management Private Limited. The methodologies will keep evolving with new insight based on the ongoing research and will be updated accordingly from time to time. Past performance may or may not be sustained in future and is not an indication of future return. Above is only for illustration purposes and should not be construed as a basis for investment. Above return does not indicate return of any offerings of NJ Asset Management Private Limited.
 

Comparative Analysis

Performance

  • Active Investing: Active investing has the potential to generate higher returns but also comes with high risk.
    Despite the potential to generate higher returns, studies conducted by S&P's SPIVA Reports for developed as well as developing markets like India, show that more than 87% of active large-cap fund managers have underperformed the S&P 500 index in the USA over the last 10 years as of 31st December 2023. (Refer to SPIVA India Year-End 2023 Report for more details on active mutual funds’ performance in India)
  • Passive Investing: Passive strategies give stable market returns. Recently, higher inflows have been seen in passive investments.
  • Smart Beta Investing: Smart beta potentially generates higher returns by leveraging on certain factors but can underperform in certain market conditions.

Risk

  • Active Investing: Higher risk due to frequent trading and future forecasting.
  • Passive Investing: Lower risk as it mirrors market performance.
  • Smart Beta Investing: Moderate risk, depending on the factors chosen and their performance.

Suitability

  • Active Investing: For experienced investors who have enough time and knowledge to manage investments actively.
  • Passive Investing: New investors or those who prefer a hands-off approach.
  • Smart Beta Investing: Investors seeking a balanced approach between passive and active investment performance. 
     

Conclusion

It is important to understand the difference between active, passive, and smart beta investing in order to match your investment approach to your risk tolerance and financial goals. Active investing may provide high returns but is time-consuming and requires adequate knowledge. On the other hand, passive investing focuses on replicating a specific market which reduces risk. This is where smart beta investing combines the best of both. Smart beta investing gives better returns through factor-based approaches. 

Each investment style differs significantly and has its own unique features. These investment styles are often incorporated by several mutual funds. Based on their preferred investment style, investors can decide to invest in active funds, passive funds, index funds, etc. 

At NJ AMC, we offer a holistic approach to investing by leveraging smart beta and rule-based investing in our mutual fund products. We focus on harnessing the power of systematic elements like value, momentum, low volatility, and quality—factors that have historically given higher returns—by following our rule-based investment style.
 

FAQs

1. What is the difference between active and passive investment strategies?

Active investment requires continuous involvement in terms of trading and time so as to outperform the market. Conversely, the passive investment technique tracks a market index, aiming to replicate market performance. It involves less frequent trading and fewer management expenses.

2. Which investment strategy, active, passive, or smart beta, is better?

The investor's objectives, risk tolerance, and investment horizon determine the optimal investment strategy. Reviewing and adjusting the investment strategy as needed will help ensure to stay on track to achieve the financial objectives. 

3. How does smart beta investing differ from passive investing?

Unlike traditional investment strategy, smart beta aims to combine active and passive investment to generate better risk-adjusted returns.

Investors are requested to take advice from their financial/ tax advisor before making an investment decision.

MUTUAL FUNDS INVESTMENT ARE SUBJECT TO MARKET RISK, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.