In recent times, we have seen that many mutual funds have come up with new fund offers focusing on factor investing. However, many individual portfolio or fund managers have been following this strategy for quite some time now. A ‘factor’ is a differentiating characteristic of a stock that gives additional returns.
While ‘factor investing’ usually requires a lot of data and numbers, understanding the factors is very intuitive. These strategies are usually constructed as a basket of stocks. Although quantitative methods are used in creating these strategies, the baskets are well diversified and more often than not, carry less risk than the Nifty index. It also scores high in terms of performance.
While the Nifty 50 Index has given around 10% CAGR since 2010, most of the factor strategies based on Nifty thematic indices have very high returns. Notable examples would be the momentum strategy which is beating the index by a wide margin and giving 20% CAGR over the same period and even factors like low volatility and price giving 2-8% higher returns over the long term. Huh. Since India has been a growth market with significant bull markets, the best performing factor in India has been ‘Momentum’ or ‘Trend Following’. The ‘growth’ and ‘quality’ factors come closely after momentum. The ‘Low Volatility’ factor gives a good performance at very low risk, while the ‘Price’ outperforms over the long term.
As the name of each factor suggests, the stock selection varies based on each factor. For example, the price factor chooses stocks that are cheap compared to their fundamental characteristics.
We need to remember that there is no single factor solution. For example, in a bull market like 2021, momentum has delivered astronomical returns, while underperforming quality and price strategies. But as the recovery began in Q4 of 2021, momentum has slowed, while price and less volatility have outperformed.
Thus, a single factor may be part of an investor’s satellite portfolio because it only works in specific market setups.
This means, depending on the market conditions, the allocation has to be shifted to the factors. For example, in a trending market like 2021, we should allocate more to momentum, but as volatility increases, we should move to a more quality and price allocation.
However, to harness the power of factors, a more innovative approach is multi-factor investing. When you combine different factors, you get an additional benefit from diversification because the factors don’t go together. Generally, in a multi-factor approach, the factors are chosen such that the relationship between any two factors is less than 50%. Therefore, if one factor in a multi-factor portfolio goes down, the other will come in for support. Thus a multi-factor portfolio will give you a good exposure due to the constituent factors and reduce the risk. Based on 10 years analysis using Nifty thematic, the multi-factor approach can give 3-5% lower risk on the index adding 5. -10% better performance over the long term.
In a bull market, a multi-factor strategy may lag behind a momentum strategy in terms of returns, and in a bear market, a low-volatility multi-factor strategy may outperform. However, this approach will have much lower risk and better risk-adjusted returns, making it ideal to be the core of one’s portfolio.
Note that these approaches are complicated for most retail investors because they require data crunching and periodic rebalancing. For exposure to multi-factor strategies, investors are better off looking for funds or advisors that follow a multi-factor approach.
Obviously, there are ways of combining factors. Some people choose their preferred factors and give weightage to them based on market conditions.
While this is a challenge, understanding and choosing a fund or portfolio manager that can dynamically allocate weights to multiple factors based on market conditions is comparable to one who allocates weight equally to all factors in a static manner. can give higher returns. all market conditions.
The bottom line is that factor investing is not only a lucrative area of research, but also a good way to generate better returns than the market at a conservative risk, mostly. These strategies rely on numbers—be it technical or fundamental—and the results will depend on the quality of the data and the construction of your portfolio.
Sonam Srivastava is the founder of Wright Research.
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