{"id":912,"date":"2022-04-01T18:21:51","date_gmt":"2022-04-01T18:21:51","guid":{"rendered":"https:\/\/sharpely.in\/blogs\/active-passive-and-smart-beta-part-1-an-introduction\/"},"modified":"2026-06-03T15:48:23","modified_gmt":"2026-06-03T15:48:23","slug":"active-passive-smart-beta-part-1-introduction","status":"publish","type":"post","link":"https:\/\/sharpely.in\/blogs\/active-passive-smart-beta-part-1-introduction\/","title":{"rendered":"Active, Passive and Smart Beta: Part 1 \u2013 An Introduction"},"content":{"rendered":"

Most of us who have been investing for a while must have heard the terms \u2013 Passive Investing, Active Investing and, off late, Smart Beta.<\/p>\n

Very simply put, these are nothing but investing methodologies (styles) that broadly covers the entire gamut of Investment strategies.<\/p>\n

In this 5-part series, we will<\/p>\n

    \n
  1. Decode these styles and how do they fit into the overall investment strategy landscape.<\/li>\n
  2. Do a detailed comparison of Active vs Passive investing<\/li>\n
  3. Deep dive into Smart Beta and factor-based investing<\/li>\n
  4. Explore the attractiveness of factor-based investing<\/li>\n
  5. Bring it all together from an investor\u2019s perspective<\/li>\n<\/ol>\n

    Active and Passive management \u2013 Introduction and definition<\/strong><\/h2>\n

    Some 20-30 years back, it was relatively easy to classify investment strategies – Active vs Passive.<\/p>\n

    Active managers manage money based on their \u201cactive views\u201d with a goal of delivering high returns (and limited risk). Active management is a very broad category. It can include stock (or bond) picking through bottom-up analysis, market timing based on some model or hunch, sector timing and rotation, thematic strategies based on long or short-term views.<\/p>\n

    Active Strategies are available as Mutual Funds, PMSs, AIFs, Hedge Funds. Recently we have seen the advent of Actively managed ETFs (ARKK Innovation ETF is an example) although no such product exists in India.<\/p>\n

    The goal of Active management has also evolved over time. With the deluge of passive investing, Active managers must outperform the benchmark on a risk-adjusted basis.<\/p>\n

    Passive Index Funds came into existence in 1970s and their goal is to match the holdings of the benchmark index to minimize the tracking error. The objective is not to outperform the index but to mimic the performance as closely as possible.<\/p>\n

    Obviously, passive management does not require any \u201cactive views\u201d or \u201cstock picking\u201d and hence the role of passive management has gradually been relegated to machines with a human (fund manager) oversight.<\/p>\n

    Passive strategies are primarily available as Index Funds or ETFs.<\/p>\n

    Given the nature of management involved, actively managed strategies (funds) are significantly more costly than passively managed funds.<\/p>\n

    Consider an example:<\/p>\n

    If you are buying HDFC Top 100 fund, you are investing in an actively managed fund. On the other hand, if you are buying HDFC Index Fund \u2013 Nifty 50 Plan, you are investing in a passively managed fund that tracks the Nifty 50 Index. HDFC Top 100 has an expense ratio of 1.19% as against 0.2% for the Index Fund (both direct plans).<\/p>\n

    Which one is the better option? Hold your horses! We will get to that in the second part of the series.<\/p>\n

    Smart Beta \u2013 A new wave<\/strong><\/h2>\n

    Off late, the distinction between Active and Passive management has blurred due to the advent of Smart Beta strategies. These strategies lie somewhere in between Passive and Active management. They have some portfolio construction characteristics of Passive management and, at the same time, seek to deliver positive risk-adjusted returns.<\/p>\n

    Before we define Smart Beta, a bit of context is required.<\/p>\n

    Warning: Slightly technical stuff ahead.<\/p>\n

    \u201cBeta\u201d in Smart Beta is the Greek letter b<\/strong>. The origin of beta can be traced to the much celebrated CAPM model<\/a>.<\/p>\n

    CAPM states that expected excess return (excess of risk-free rate) on any security is proportional to excess return on the market (the equilibrium portfolio) and that proportion is the security\u2019s exposure to the market and is the security\u2019s beta.<\/p>\n

    ERi – Rf =\u00a0bi x (ERm – Rf)<\/em><\/p>\n

    Very simply put, CAPM states that exposure to market is your only source of rewarded return \u2013 market is the ONLY risk factor that is rewarded.<\/p>\n

    Years later, the CAPM model was extended by the Arbitrage Pricing Theory (APT). APT stated that there are other factors beyond the market that earned positive risk premia and the only source of expected returns are the exposure (betas) to these factors. In a sense, APT posited the existence of other risk factors (that are rewarded) beyond the market.<\/p>\n

    ERi – Rf =\u00a0bi1F1 + bi2F2 + bi3F3 + bi4F4 + \u2026 + binFn<\/em><\/p>\n

    Smart Beta strategies are direct decedents of the Arbitrage Pricing Theory. These strategies aim to get exposure to one or more risk factors to harvest the underlying risk premium.<\/p>\n

    Smart Beta strategies use a transparent rule-based portfolio construction mechanism to take factor exposures. In that sense, they resemble passive strategies. On the other hand, Smart Beta strategies frequently rebalance, and their goal is to deliver positive risk-adjusted returns. In that sense, they resemble active strategies.<\/p>\n

    Smart Beta is sometimes misunderstood as Factor Indices (e.g., Nifty 200 Momentum 30 Index). While these indices are indeed Smart Beta indices, Smart Beta strategies are not limited to these indices.<\/p>\n

    Consider some examples:<\/p>\n