Have you watched one of the movies where the plot is tense, and there’s a tricky problem at hand, and suddenly someone applies data and pattern detection techniques and finds a solution?
Factor Investing is an effort to do the same for long-term investing. Factor investing is an effort to use data and algorithms to find distinguishable patterns in the market that can help us consistently outperform the market at low risk.
What are these Factors?
Factors are indicators that can help describe stock returns. When you try to get into the details of the factors influencing market returns, you’ll find that they are very intuitive to understand.
Factors are of two main types - macroeconomic and style factors. Macroeconomic factors are broad-based, like the GDP growth rate, inflation, unemployment, etc.
Style factors are more nuanced and are a quantitative way to describe strategies for outperformance. Each of these style factors would have proponents among quantitative investors and all types of investors.
Some prevalent factors
Value: This factor aims to capture the premium associated with stocks with low prices relative to their fundamental value.
Size: This factor says that small-cap stocks exhibit greater returns than portfolios with just large-cap stocks.
Momentum: This factor bets on the outperformance of stocks that have historically exhibited strong returns.
Quality: Stocks with strong corporate governance and consistent earnings with low debt are called quality stocks that tend to outperform.
Volatility: This factor bets on the phenomenon that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets.
Benefits of Factor Investing
Factors allow investors to find stock themes that fit their risk appetite and enable them to invest in a unique opportunity. Investors can get exposure to multiple factors, thus increasing their diversification and consistency or returns. Tactical allocation to Factors, while challenging, can be highly lucrative.
Factors being data-driven can focus on a broad universe. They capture all significant fundamental anomalies in the market and behavioral biases. They allow the investors to get greater diversification, thus lowering their drawdowns.
Factors can be served in a passive or an active basket. As these baskets are data and technology-driven, they have low expense ratios.
Risks of Factor Investing
Factor returns can be cyclical, and any factor will not work all the time. On the other hand, a single factor can have extended periods of underperformance like the value factor had in the last couple of years when Momentum outperformed.
So, it is always a good idea to trust an investment advisor that guides you with a tactical allocation to factors. Factor maths is also quite complex, so investors should generally trust practiced researchers in the field.
Factor Investing in India
The NSE has published factor Indices since 2017, and there are some ETFs available for the same as well. In addition, Robo-advisors like Wright Research also publish curated factor or smart beta strategies, which are very popular on smallcase.
Talking about the relative performance of Factors in India, Momentum or Trend Following has always been an influential factor for Indian investors because India has gone through strong growth markets.
Quality is also a factor that works well in India, along with Size or betting on smaller stocks. In times of volatility, Value or Low Volatility factors outperform the market.