Everything about factor investing

Factor investing is an investment strategy that combines active with passive styles of investing in order to capture excess returns at a reduced level of risk. Funds following this approach are constructed to target specific stocks that exhibit a characteristic that drives returns. This approach to investing is relatively new in India but is lately gaining ground in the mutual fund industry. Many investors are getting keen to know if these schemes can prove to be a good bet for their portfolios.  

Types of factors:  

Fund managers use five factors – value, growth, quality, momentum, and volatility — to build indices generate smart beta or alpha strategies in order to earn returns higher than the benchmark. 

Value-based approach is used to screen stocks, which are undervalued in the market in terms of P/E and P/B ratios. A growth-based approach is used to check alpha (a measurement of performance) of stocks of companies, which is determined from earnings as well as revenues. 

Quality-based approach is used to check the quality score of the stock determined by return on equity, debt to equity along with earnings per share growth and other factors. The momentum-based approach focusses on the opportunities that will generate strong returns due to the momentum in the past returns. Volatility-based approach is used to determine the level of volatility of stock using standard deviation to ensure returns are not much affected. Sometimes a combination of two or more factors results in multi-factor indices.  

 Active & passive strategy  

The 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.  

Prominent funds:  

In the last one year, factor funds have offered an average return of 48.03 per cent. DSP Equal Nifty 50 Fund and Sundaram Smart Nifty 100 Equal Weight Fund are the top performing funds, offering 60.18 per cent and 54.38 per cent returns, respectively in the past one year. 
 

Pros & cons of factor investing  

A factor fund allows mutual fund investors to invest in a basket of stocks according to their risk appetite and preferred investment style. It provides exposure to multiple factors within one vehicle, giving investors a higher probability of achieving risk-adjusted returns. Factor-based models give diversification benefits. Besides, the advances in technology and data analysis, more enhanced tools & processes are being used to construct more factor-based mutual fund portfolios, which give an advantage to investors to choose multiple funds. 

The returns are cyclical in nature as not all the factors work all the time, which means that there can be extended periods of underperformance. In recent years, several funds have started using factor investing strategies. Retail investors have to as poorly constructed strategies could expose investors to undue risks and unprecedented circumstances. 

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