Explained: Concept of factor investing
The approach to factor investing is relatively new in India but is gaining ground in the mutual fund industry.
One of the most striking questions linked to mutual fund investments is whether one can side-step equity mutual funds and take comeplete charge of their investments directly? The answer is obviously yes but what is the best possible way to go about it? Industry experts often point towards factor investing as a potential solution to this dilemma. Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. There are two main types of factors which include macroeconomics and style.
“Investing in factors can help improve portfolio outcomes, reduce volatility and enhance diversification. These factors are broad, persistent drivers of return critical to helping investors seek a range of goals from generating returns, reducing risk, and improving diversification,” said Avinnash Gorakshakar, research director at Profitmart Securities.
The idea behind factor investing is primarily this – all companies in your investment universe are ranked basis one specific attribute to build a portfolio. The investor should be overweight in high-ranking stocks and underweight in low-ranking stocks.
Factors are fundamentally broad, persistent characteristics that can both impact and drive asset returns.
They are generally persistent over time and have consistently demonstrated an ability to explain stock returns. Over the last 50 years, academic research has identified hundreds of factors that impact stock returns.
Knowing these factors and exposing your portfolio to such factors, can help investors generate alpha. Most well-recognised examples of factors are economic growth, inflation, credit standing of a corporate, interest rate changes, yield, etc.
“During economic growth, it is more likely that the companies will increase their profits due to increased consumer spending. However, it is not always like that, for during downturns in the economy, companies can get in to problems leading to a decline in stock prices. Meanwhile, inflation affects the stock prices because it mainly affects the people’s ability to spend as they used to do before. So whenever the prices of goods get higher, consumers are less likely to spend money. As a result, it negatively impacts businesses,” Gorakshakar explained.
Credit standing of corporates and interest rate changes
Factor investing based on a company’s credit involves investing in stocks that compensate the investor for holding onto a stock with default risk. Different types of bonds come with varying degrees of default risk, so investors should choose specific bonds with exposure to the market risk.
The climb in interest rates put a stop to businesses and individuals from borrowing money or taking out loans from the bank. Accordingly, consumer spending also gets impacted and economic activity as well. Yield is also an important factor that captures the excess returns of stocks which have a high dividend yield.
Well-balanced strategy
“Institutional investors and active managers have been using factors to manage portfolios for decades. Today, data and technology have democratized factor investing to give all investors access to these historically persistent drivers of return. Minimizing a portfolio’s exposure to risk could be the best advantage one can gain from adopting factor investing. It is mainly related to the benefits of diversification provided within,”Gorakshakar pointed.
Style and macroeconomic factors cover various situations in the economic cycle, and they improve the quality for diversification. Factor investing is linked to high profits & returns due to the balanced strategy regarding choosing the stocks based upon some delicate traits that have historically generated positive earnings.
Implication on investors
Factor performance tends to be cyclical, but most factor returns generally are not highly correlated with one another, so investors can benefit from diversification by combining multiple factor exposures. Factor-based strategies may help investors meet certain investment objectives such as potentially improving returns or reducing risk over the long term.
“Factor-based investment strategies are founded on the systematic analysis, selection, weighting, and rebalancing of portfolios, in favor of stocks with certain characteristics that have been proven to enhance risk-adjusted returns over time. Most commonly, investors gain exposure to factors using quantitative, actively managed funds or rules-based ETFs designed to track custom indexes,” Gorakshakar asserted.
Factor-based investment strategies can be compelling options because they provide investors with targeted and streamlined access to factor exposures. The factor approach has gained popularity because indices constructed using the factors of value, quality, size, momentum or volatility have outperformed traditional equity indices constructed by reference to market cap over the long term.
Who should opt for factor investing?
The approach to factor investing is relatively new in India but is gaining ground in the mutual fund industry. These are useful for both Institutional and Retail investors. Here, the fund managers of factor funds passively track the factor-based Nifty indices which are actively managed.
Nifty Value 20 index, Nifty Quality Low-Volatility 30, Nifty100 Low Volatility 30, Nifty200 Momentum 30 and Nifty Alpha Low-Volatility 30 are some of the widely-used factor indices. By using the combination of the above mentioned five factors, stocks are selected and their weights are capped in the index.
Performance of factor investing
“Quant Investing works. All the Factors like Growth, Quality, Value and Momentum have proved that Factor premium exists in India. Fundamental research with forecasting has to be blended with Quantitative Factors to deliver superior results. Thus, a Quantamental approach (Quantitative + Fundamental) should deliver superior performance over time,” Gorakshakar concluded.
Indian market has given the highest premium for growth, followed by quality and then value, based on prospective data. Hence, it’s a good bet if you’d like to build your own portfolio and looking for a smart strategy to fall onto.