Last 10 years has seen emergence of Index Funds and ETFs in India. From a 2% of overall AUM in 2014, it has grown to over 17% in June 2024 (with total AUM greater than 10,00,000 crores). This rapid expansion has prompted Asset Management Companies (AMCs) to innovate and introduce new strategies to cater to the evolving needs of investors. Among these strategies, factor investing has emerged as a prominent approach, offering a sophisticated method to enhance returns, manage risk, and achieve better diversification.
Factor investing involves targeting specific factors within securities that have the potential to generate returns. Factor funds in India are predominantly available at low cost in Index Fund and ETF format. By focusing on specific attributes such as quality, value, size, momentum, and low volatility, factor investing allows investors to tailor their portfolios more precisely to their financial goals. For instance, Value Investing is a subset of factor investing that target securities that are undervalued, aiming to capitalize on market inefficiencies. On the other hand, Momentum Investing seeks out securities with upward price trends, banking on the continuation of these trends.
Benefits of Factor Investing
Wealth Creation: Factor investing aims to capture specific drivers of returns which have historically outperformed the market. It works everywhere across different markets, asset classes and time periods. By systematically applying factors, investors can achieve a more robust and resilient portfolio, capable of adapting to diverse economic conditions and market environments. According to research available, factor investing has historically outperformed market benchmarks; if used effectively can offer long-term wealth creation for investors.Risk Management: Factor investing helps manage risk by targeting factors that perform well in different market conditions. For example, low volatility stocks tend to perform better during market downturns, providing a cushion against losses. This approach can help relatively stabilize the portfolio during volatile periods.
Transparency: Like any other passive funds (Index Fund & ETF), factor investing strategies are often rule based, meaning they follow a clear set of criteria for selecting investments. This transparency allows investors to understand the rationale behind investment decisions, making it easier to monitor and manage their portfolios.
Diversification: Factor investing can enhance diversification by spreading investments across various factors that are not highly correlated with each other. This reduces the impact of any single factor underperforming. Factor tends to have less correlation among each other, globally investors and advisors prefer to blend individual factors to seek better risk-adjusted returns.
Accessibility: Advances in data and technology have made factor investing more accessible to individual investors. Tools and platforms now allow for easy implementation of factor-based strategies. Factor investing offers a structured approach to portfolio construction that can enhance returns, manage risks, and provide cost-effective investment solutions.
Key aspects to keep in mind before adopting the Factor Investing approach:
Factors can experience periods of underperformance. For instance, value stocks may underperform growth stocks during certain market conditions. Overexposure to a single factor can result in significant losses if that factor underperforms. Accurately identifying and capturing factor premiums requires sophisticated models and extensive data analysis, with errors potentially leading to underperformance. Changes in market conditions or investor behaviour can impact the effectiveness of factor strategies. For instance, if a large number of investors start using the same factor strategy, the factor premium may diminish.
Understanding these risks is crucial for investors looking to implement factor investing strategies. Diversification across multiple factors and continuous monitoring of market conditions can help mitigate some of these risks.
Investor Profile
Investors can tailor their portfolios to target specific factors that align with their investment goals and risk tolerance. For example, an investor with a higher risk tolerance may allocate more to factors like momentum or size, which can be more volatile but offer higher return potential. Those seeking stable income might focus on quality and low volatility factors, while growth-oriented investors might prioritize value and momentum. Globally sophisticated investors and advisors also adopts to blending ‘True to Label’ factors to form their core allocation to equity portfolio.
In conclusion, factor investing offers a systematic approach to capturing specific drivers of returns. While it presents opportunities for enhanced returns and risk management, investors must be mindful of the associated risks and align their strategies with their individual investment profiles. By understanding and carefully selecting factors, investors can position themselves to achieve their financial objectives more effectively.
(The author Vikash Wadekar is Head of Passives Business, Axis Mutual Fund. Views are own)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)