In FY24, smart-beta indices performed better than the Nifty 50, with low-volatility funds outperforming by as much as 6-12%, reported moneycontrol.com. With 56 smart beta funds and roughly INR 16,000 crore in assets under management (AUM), Factor Investing is gaining momentum in India.
In recent years, we’ve observed an interesting shift in the investment ecosystem. As large-cap fund managers faced challenges in outperforming their benchmark indices, many investment houses began offering passive strategies like index funds and ETFs. This trend has persisted, even as markets have experienced various fluctuations and changes. This evolving dynamic highlights the importance of a balanced approach to asset management – one that bridges the gap between active and passive strategies. Factor Investing offers a systematic solution for optimizing returns while capitalizing on prevailing market conditions.
What is Factor Investing?
Factor Investing is an investment strategy that targets specific characteristics, or “factors,” of stocks to enhance returns and manage risks. It combines elements of both active and passive investing to achieve the best of both worlds. Here’s a quick breakdown:
- Focused Strategy: Targets specific stock characteristics to enhance returns and manage risks.
- Balanced Approach: Uses a rule-based method to select and weight stocks.
- Diversification: Combines different factors for improved diversification.
- Performance: Seeks better risk-adjusted returns and more stable long-term performance.
Key Factors in Factor Investing
Factors in Factor Investing are categorized into Macroeconomic and Style factors:
Macroeconomic Factors:
- Economic Growth: Boosts stocks during economic expansion.
- Interest Rates: Falling rates boost stocks.
- Inflation: Rising prices reduce purchasing power, affecting stocks.
- Credit: Loan availability impacts investment and spending.
- Liquidity: Ease of converting assets to cash affects stability and volatility.
Style Factors:
- Dividend Yield: Higher-yielding stocks provide superior returns.
- Size: Smaller firms tend to be high risk, high reward.
- Quality: High profitability and stable companies outperform.
- Value: Cheaper stocks outperform expensive ones over time.
- Momentum: Stocks that have performed well tend to continue the trend.
- Low Volatility: Lower volatility stocks offer higher risk-adjusted returns.
Things to Consider in Factor Investing
Benefits:
- Outperform Benchmark: Focus on historically outperforming factors like value and momentum.
- Systematic Approach: Uses tried-and-tested strategies in portfolio construction.
- Transparency: Helps understand the rationale behind investment performance.
Drawbacks:
- Complexity: Requires a solid understanding of financial metrics and market behaviours.
- Historical Data Bias: Reliance on past performance may mislead current decisions.
- Selection Bias: Reliance on favourable backtest results can lead to poor decisions.
Note: While factor investing can offer benefits, it’s important to note that some factor-based products may be restricted to accredited investors due to their complexity or regulatory requirements
Dezerv’s View
A key benefit is the cyclicality of factors – since different factors perform well at different times, combining them can provide diversification benefits. This diversification helps smooth out returns and reduces the impact of any single factor’s underperformance. While complexities and risks exist, a well-balanced Factor Investing strategy can be a powerful tool for achieving long-term financial goals.
We’ve created an easy-to-understand cheat sheet that explains:
- What is Factor Investing?
- Key factors involved in Factor Investing
- Things to consider in Factor Investing – benefits and drawbacks
- Opportunities and challenges that investors should carefully consider
Check out our Factor Investing cheat sheet, and let me know your thoughts in the comments below!
Disclaimer: The information contained herein is for informational purposes and should not be interpreted as soliciting, advertising, or providing any advice.