Factor investing combines the best of both worlds
PremiumA factor allows for identifying a basket of stocks subject to one’s risk-return appetite
Factor investing (FI) is a strategy being increasingly embraced by investors as the third style of investing, in addition to active and passive investment. It seeks to combine the benefits of both active and passive investing strategies. The goal is to obtain alpha (excess return of an investment relative to the return of a benchmark index), and to increase diversification at a cost lower than traditional active management, albeit marginally higher than straight index investing.
The issues inherent in both actively and passively managed strategies have been instrumental in the rise of FI. Actively managed strategies are usually based on conviction-driven allocation, sometimes leading to biases; and they attract higher fees than passive investing in their quest to deliver better-than-benchmark returns. However, in the recent past, most large-cap, actively managed funds are finding it difficult to outperform the benchmark. Investing in the Nifty 50 Index Fund, or ETF, is an example of a passive strategy, wherein one will never be able to outperform the Nifty 50 Index due to expenses. FI offers the benefits of both active and passive investing as it is targeted at a low-cost, transparent framework, with a quest to generate higher returns.
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A lot of research has already been done on this strategy globally; more than 300 factors have been identified and their performance has been tracked for decades. In layman’s terms, a factor is any characteristic that explains the risk and return of a group of securities. There can be single factor or multiple factors required to analyze, explain and build investment strategies.
Some common single factors are quality, value, alpha and low volatility. A combination of two or more factors results in multiple factors such as quality-low volatility and alpha-quality-low volatility. As Andrew Ang, a pioneering academic advocate of factor investing from Columbia University, put it: “Just like ‘eating right’ requires you to look through food labels to understand the nutrient content, ‘investing right’ means looking through asset class labels for the underlying factor risks. It’s the nutrients in the food that matter. Similarly, the factors matter, not the asset labels."
There are various approaches to using factors in an investment strategy, commonly labelled “smart beta", which has gained considerable traction in recent years. Smart beta is a simple and transparent form of FI. The growth of smart beta stems from two main sources: dissatisfaction with traditional active strategies, and evidence that simple, rule-based approaches can do better than market capitalization weighted indices.
Across the globe, FI has rapidly gained popularity across segments from the large institutional investor to the savvy ultra high net-worth and high net-worth individuals, family offices and retails investors. Smart-beta funds are more popular globally with $1.12 trillion (about ₹83 trillion) worth of investments, according to ETFGI’s March 2021 ETFs and ETPs Smart Beta industry landscape insights report. ETFs are exchange-traded funds and ETPs are exchange-traded products.
A factor allows for identifying a basket of stocks subject to one’s risk-return appetite and preferred investment style. Different factors display strengths and weaknesses in different economic and market environments. Factor indices have yielded astounding returns outperforming broad indices across time horizons and business cycles. Nifty Alpha 50 has consistently performed well across various upcycles, followed by Nifty 200 Momentum 30. During down cycles, the Nifty Low Volatility 50 performed well, followed by Nifty 200 Quality 30.
With this, one can clearly say that FI has truly arrived and is going to be an important investment strategy for all. And its acceptance is only expected to rise with time and will witness higher and wider investor participation from institutions and high net-worth individuals to retail investors as well.
Prashant Joshi is co-founder, Fintrust Advisors.
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