The investing world has for many decades seen investment portfolios managed in a combination of active funds and passive funds. By now, we must already be familiar with these two styles of portfolio management. To the uninitiated, active funds promise potentially higher returns on the basis of active stock selection but come at a bit higher cost and complexity. By contrast, passive funds simply replicate an index and helps an investor enjoy that market portfolio in a transparent and cost-effective manner but without any promise of market outperformance.
Active funds have dominated Indian markets for very long and will perhaps continue to dominate for many years. In recent years, passive funds have started to make their presence felt in Indian markets, even though the size is relatively small at 10% of the mutual fund industry. Passive funds though have been very popular in many developed markets. With rapid technology growth and innovation, we are now seeing a new approach to portfolio construction - rule-based active investing in India. This new approach is said to employ the best elements of both worlds.In this article, I will try to decode this new style of investing...
Rule-based active investing is an attempt to capture the benefits of both extreme approaches - active & passive investing. The basic idea to use to implement active strategies which are driven by rules /models, removing human intervention for stock selection. This helps in removing any biases, mistakes and increases diversification and greatly increases the stock universe for evaluation since the process is automated. These rules /models are often developed in-house and are transparent, systematic, and run at relatively lower costs.
Rule-Based active investing or smart beta strategies rely more on data and make use of financial data scientists instead of traditionally relying solely upon fund managers. With the huge amount of data available, technology today can be trained to identify, validate and implement rules in a disciplined manner. As a result, rule-based active investment techniques have today become more sophisticated and precise and can even run on a real-time basis.
One of the popular strategies within rule-based investing is factor-based investing, which seeks to select stocks that have certain desirable characteristics (called factors) that contribute positively to performance. The idea is to use these time tested factors to identify stocks that show potential to deliver superior returns and eliminate the potential risky ones.
Interestingly, we now have products that go beyond just stock selection and even employ rules /models to decide on the asset allocation - i.e., the allocation between equity and debt within a single fund.
These funds thus employ rules to decide two things,
(i) asset allocation
(ii) stock selection
Factors
Factors are the core element of any rule-based investment strategy. The factors are broadly the parameters or the check-points, based on which any decision /result is given by the model in simple terms.
For stock selection, market factors like volatility and momentum and factors like value and quality evaluating the fundamentals of the stocks are used. Additionally, for funds with asset allocation strategy, factors evaluating the economy and the equity market indicators are used to decide the allocation between equity & debt.
For e.g., equity valuations, interest rates and the government security yields. In such funds, both the sets of factors play together to offer the opportunity to calibrate exposure to equities and thus reduce the volatility experienced by investors when they invest in such funds.
Though it may sound simple, within each of these factors, again multiple measures, indicators may be used. A lot of time goes into developing factor attribution tools and a factor library. This involves innumerable simulations, correlations, back-testing, etc to arrive at the best combination that promises optimal returns and the lowest risks. The rules /models are also pre-tested for volatility and performance with historical data for different market scenarios.
The asset allocation, stock weights and even the weightage between factors are all decided based on proprietary protocols. This proprietary logic and intelligence are of great value and what differentiates such model /rule-based funds. All this also very clearly differentiates the rule-based active funds from the predominantly active approach, as well as passive replication strategies of a majority of mutual funds today.
Benefits of Rule-Based Active Investing
The rule-based active investment strategy attempts to offer the best of both worlds, combining rule-based discipline with potential outperformance of active stock selection with rules.
Further, with rules-driven stock selection, the universe of stocks being evaluated also becomes unrestricted as it is automated and not dependent on human research /inputs, promising better diversification & identification of opportunities.
Funds with a dynamic asset allocation approach further ensures that both asset allocation and stock selection happen based on rules without any human intervention.
This makes the process inherently disciplined and eliminates human bias or any scope for human mistakes /oversight. This process is repeated at predetermined intervals, which allows the portfolio to change with the times like in an active fund but with lower costs.
Investing in a rule-based active fund
As investors, we are often looking for ways to diversify our portfolios and reduce risks. A rule-based active fund presents an opportunity for diversification at the style level for an investor. A fund that offers in-built asset allocation between equity and debt is also tax efficient as the same is managed internally without the need for the investor to allocate capital between multiple schemes /funds.
It is thus also easier to manage and invest in for investors looking for such asset allocation solutions.
As we always maintain, any investment decision should be driven purely by the needs of the investor and his/her risk profile.
Every type of fund - be it active, passive or rule-based active fund, have their own space and audience. As wise investors, we should be aware of the investment options available with us. And with new innovations and products, investors should also be happy to have more choice and diversification opportunities.
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