Factor investing is an investment approach that involves designing a portfolio of stocks, based on a certain factor or set of factors. Also called as Smart Beta investing, let us see what it entails.
Smart beta investing or Factor Investing has been gaining prominence in recent years, owing to its ability to help create a curated basket of stocks which is aligned to an investor’s personality.
What are the Factors
The factors here can be value, momentum, quality, price, alpha, low volatility etc. In India, smart beta strategies are passive in nature and are available for investing either in the form of ETF or index funds. While building your personalized portfolio using factor investing, you can choose one or combine several of these factors, in line with your requirements.
For each factor, there are a set of parameters involved owing to which the entire process of portfolio building is rule based. As a result, human bias is non-existent in the investment decision making process. Also, factor investing does not rely on market capitalization.
For example, if an investor wishes to have an element of growth in his portfolio, investing in a growth based smart beta offering can be a good starting point.
In case of alpha based offering, the index will consist of names with high alpha over the last one year.
Similarly, in low volatility based smart beta offering, stocks which were the least volatile over the past one year would be chosen.
When it comes to momentum-based factor offering, the portfolio will have a set of stocks which would have depicted strong price performance in the recent past, and this momentum is likely to continue in the months ahead.
In value factor, the aim will be to have a set of companies with robust fundamentals which are trading at a discount to its intrinsic value but have the potential to deliver superior returns over time.
When it comes to quality factor, the index will consist of companies with strong fundamentals, with stable earnings, low debt levels, and high profitability.
Two Broad Categories of Factors
Like the economy and markets, all these factors also tend to be cyclical. Not all factors perform similarly at the same time and keep changing, though, over long periods, most of them tend to outperform the broader market. The investment theory, thus, is that if one can identify the prevalent factors at any point in time, the security selection across sectors can be made automatically based on the factors.
With hundreds of research papers having been written on the subject, the most popular strategies are focused on the following two kinds of factors of investing:
Macroeconomic Factors – like inflation, interest rates, etc.
Fundamental Factors – like value, size, quality, etc.
While macroeconomic factors are useful in broader asset allocation (deciding allocations to different asset classes like debt and equity), the fundamental factors are more focused on identification of specific equity securities tilting towards each of these factors at any point in time.
As a clear example, we are recommending our Elite Program subscribers to make use of the interest rate factor in the current macro-economic scenario and start investing in debt funds before the interest rates start to fall.
Some Examples of Smart Beta Funds
- DSP Equal Nifty 50 Fund
- Principal Nifty 100 Equal Weight Fund
- Sundaram Smart NIFTY 100 Equal Weight Fund
- ICICI Pru Nifty Low Volatility 30 ETF
- Edelweiss ETF – Nifty 100 Quality 30
- Kotak NV 20 ETF
- Nippon India ETF NV20
- ICICI Pru NV20 ETF
- SBI Quality 30 ETF
- ICICI Pru – Nifty Alpha Low Volatility 30 ETF
Should you try factor investing
The answer is YES and NO. or we can say, it depends.
While many investors are considering factor investing to generate smart beta over benchmark indexes, whether you should try it or not depends on your unique investment goals, risk tolerance, and time horizon. Factor investing can be an option if you are keen on realizing enhanced returns or risk reduction beyond what traditional index investing provides. Further, your risk appetite must align well with the specific risks associated with the chosen factors – for instance, momentum investing may involve higher volatility, while value investing could face periods of underperformance.
Separately, factor investing is generally considered a long-term strategy since its benefits often become more apparent over extended periods so if you have a shorter investment horizon, factor strategies may not align with your goals. If these aspects align with your investor profile, it is advisable to conduct thorough research on the factors you intend to use and the available investment options, while considering aspects like historical performance, factor purity, and expenses associated with factor-based ETFs or index funds.
As market sentiment and the economic cycle change, the predominant factors in the stock market also change from time to time.
To conclude, factor investing can be used to build a curated portfolio, which over time can help generate superior risk-adjusted return. With the help of an advisor, investors can capitalize on the changing market trends, using these factor indices.
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