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Factor Investing: Is it the NextGen alpha return strategy?

Factor investing is a type of investment approach in which fund managers pick stocks based on specific characteristics. These characteristics are what drive stock returns. In this article, we are going to dive deeper into various aspects of Factor Investing.
Factor Investing

Factor investing has taken the Indian investment world by storm ever since its arrival. While this mode of investing is relatively new for many Indian investors, it makes them curious at the same time. this investment strategy, This investment strategy in particular made its strong presence in the mutual fund industry. So what is factor investing, how does it work, and most importantly, do investors need to employ this strategy for their investment? This article walks you through all the ins and outs of factor investing and will make you more informed about the same.

What is Factor Investing?

Factor investing is one of the investment strategies to balance the portfolio and drive returns. It combines both active and passive investment styles to help investors achieve better returns while minimizing the risk. Within factor investing, the funds target specific stocks believed to have the competency to deliver superior returns. These stocks are selected and evaluated based on predetermined investment styles and macroeconomic factors, and hence factor investing got its name.

Although the factor investing concept is relatively new in India, it isn't that new. Its roots go back to the 1960 Capital Asset Pricing Model (CAPM) theory, which explains how assets are sensitive to market risks.

How does Factor Investing Work?

The predictors and driving forces of factor investing are factors, namely investment style, and macroeconomic factors.

  • Investment style factors: Help understand returns and risk within asset classes. Using these factors, a fund manager can form performance and risk expectations of any particular stock. These factors include the value, growth, quality, momentum, and volatility of stocks.
  • Macroeconomic factors: Help understand broad risks across asset classes. These factors are essential for a well-planned and diversified investment strategy to earn good returns. Macro factors include interest rates, economic growth, credit risk, liquidity, and inflation.

These factors can work together or even individually in order to generate an excess return with reduced risk. Based on these factors, fund managers develop smart beta or alpha strategies. Fund managers assess and determine whether a particular stock meets the investment qualification.

Factors that hold prominence in a particular market help diversify portfolios while lowering volatility. They also improve portfolio performance over time, helping investors make the most of their investment in line with their risk appetite.

Critical Components of Factor Investing

The components of factor investing include all the investment style factors. Investors and fund managers must evaluate the following investment factors before employing the factor investing strategy for portfolio management. 

  • Value: Capture stocks that are undervalued in the market in terms of price-to-sales, price-to-book ratios, and dividend yield. 
  • Size: Small-cap stocks yield more returns than large-cap portfolios. Since small-cap companies are less stable than large caps, they are riskier but have more scope for growth which can drive outstanding returns. 
  • Quality: Checks the quality score of the stock. Stocks with high profit earning capabilities tend to outperform with time. It considers aspects such as return on equity (ROE), return on capital employed (ROCE), debt to equity (D/E), and earnings per share. 
  • Momentum: Identify the opportunity to generate strong returns against the past performance of stocks. It considers aspects like point-to-point past returns and historical alpha. 
  • Volatility: Determines the stock volatility in terms of standard deviation and downside standard deviation to generate better returns. Stocks with low volatility have historically performed better. 

Advantages and Disadvantages of Factor Investing

Advantages Disadvantages
- Offers diversification in the investment
- Improves portfolio performance and thus returns
- Involvement of multiple factors reduces volatility
- Give investors exposure to overlooked, yet high-performing stocks
- Compliments other investment strategies
- Factor funds may perform differently in different market environments or in changing market environment
- Too much focus on certain factors can result in concentration risk
- Improper utilization of a factor investing strategy may put you at risk  
- Complicated investment strategy for novice investors 

Factor Investing Trends in India

Over the past couple of years, many funds have started using factor investing strategies. Various forms have been tested and applied to portfolios to identify the effectiveness of the factors. While popular smart-beta funds have utilized a single factor approach, such as UTI Nifty 200 Momentum30 Index Fund: Momentum factor, SBI ETF Quality factor, and Kotak NV20 ETF: Value factor, others employed a more advanced approach of multi factors to deliver better risk-adjusted returns over time and have been performing well, such as ICICI Prudential Alpha Low Vo l30 ETF.

In the current scenario, investment style factors such as size, value, volatility, and momentum are seemingly easier for funds to understand and apply across the market. Quality has also worked well in India but needs more research in terms of variables that are being tested. 

Factor Investing_1

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One of the emerging trends in factor investing is the introduction of multi-asset funds (such as stocks, gold, or bonds). As the risk is becoming a more and more prominent factor, there will be a surge in risk-lowering hybrid products such as multi-asset allocation funds, balanced hybrid funds, aggressive hybrid funds, balanced advantage funds, and more.

And with more and more AI-based tools being introduced, it's now easier to gauge macroeconomic factors and perform portfolio allocation to different asset classes. 

Is Factor Investing right for you?

Factor investing can be the right investment strategy for many right reasons. 

  • Factor investing complements other investment strategies that investors already have employed for portfolio management.
  • It is data-driven and covers broader anomalies in the market, allowing investors a better way to portfolio diversification and lower drawdowns.
  • With factor investing, investors can select stock themes in line with their risk appetite, which allows them to gain unique investment opportunities.
  • It offers a scientific approach to portfolio management, investors use empirical data for asset allocation, and the risks are reduced, ensuring better than average returns. Besides, it cuts overall portfolio costs.
  • Factor investing possesses strong defensive characteristics to volatility and thus potential to minimize downside risk.
  • Factor investing can be used for both active and passive baskets of funds. Since these baskets are data and technology-driven, they have comparatively fewer expense ratios.

Should investors consider using a Factor Investing Strategy? 

It depends on the investors and their understanding of different factors. If an investor captures the correlation between various factors and stocks, perhaps he can capture top-performing companies and sectors in their portfolio and generate longer-term alpha returns over time. 

However, factor investing does come with its fair share of risks, which we have discussed above. Though factors can outperform the broad market over the long term, they also have long periods in history wherein they have underperformed the market or had significant drawdowns. Fund managers can work around factor investing by knowing the factors (investment and macroeconomic factors) that can drive returns and diversify them with the right mix of assets and strategies.

Conclusion

Factor investing has a tremendous potential to generate better-than-average returns and reduce risk. While its acceptance will rise over time with many investors participating, currently, it's very much novel for Indian investors. A lot of understanding and research isare still required. Hence, investors should employ factor investing by combining it with other strategies for portfolio management and not use it as a sole investment method.

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