Several mutual funds have started launching multi-factor funds. Unlike single-factor funds, these funds invest across factors such as value, quality, momentum, low volatility.
Different factors tend to do well in different phases of market and such funds aim to offer diversified exposure and navigate better through changes in market phases.
This article explains what multi-factor funds are, how they offer diversification and whether you should invest in them.
What are multi-factor funds?
Single-factor funds focus on a specific factor from among factors such as low-volatility, value, growth, quality, momentum, alpha, etc. These single-factor funds may do well in a specific cycle of the market. For example, in momentum, funds are likely to do well during sustained phases of bull market or when market bounces back during a recovery phase.
Popular among these are momentum single-factor funds with assets under management of ₹18,582 crore. In three-year period, momentum as a factor has delivered about 30% returns, while in one-year period, the factor has delivered negative 8% returns. It shows how factors go through phases of underperformance at regular intervals.
Unlike single-factor funds, multi-factor funds can move across factors and are likely to navigate better through changes in market phases.
As this is still a new category for fund houses, Sundaram MF, Mirae Asset MF, and Bandhan MF have recently launched their multi-factor funds.
How does multi-factor funds offer diversification?
“These funds take the pressure off timing the market. Multi-factor funds tend to play out better across market phases. For example, a fund might allocate more to momentum during market recovery, as market volatility sets in it can make the switch to low volatility factor and when market is in consolidation phase, it can shift to quality factor,” said Nirav Karkera, head of research at trading platform Fisdom.
Quality stocks refer to companies that tend to generate earnings with steady growth. Momentum factor identifies stocks that have shown strong returns in recent past.
“It is advisable to have a combination of factors that have low correlation with each other. So, when one factor underperforms the other can cushion the portfolio,” said Kavitha Menon, founder of wealth advisory firm Probitus Wealth.
In 2007, the alpha factor delivered 91.8% returns, while the value factor delivered 109% returns before the 2008 financial crisis. Meanwhile, the low-volatility factor lagged with 31% returns. The alpha factor aims to track stocks that have outperformed the market benchmark, while the low-volatility factor, as the name suggests, focuses on stocks that tend to show less volatility during market downturns.
Around the time of covid-19 outbreak, the best factor was quality, delivering 26.3% returns in 2020, with value and momentum underperforming.
During market recovery in 2021, value and alpha were the top-performing factors with gains of over 56% each. The momentum factor was also close with 51% gains in the same period. Low-volaity and quality factor underperformed.
Should you invest in multi-factor funds?
As the above data points show single factor is unlikely to do well across market phases, hence a multi-factor approach is more suitable for those new to factor investing. Timing the switch from one factor to another as market dynamics change is not easy.
But dabble in factor investing after you have exhausted your regular equity categories for your core portfolio. For more savvy investors, such funds can be considered as part of their satellite portfolio with allocation capped at 8-10%.
“Multi-factor funds can be a good starting point for factor investing, but only after the investor has spent considerable time in the equity markets,” said Kirtan Shah, founder and chief executive officer of financial services company Truvanta Wealth.