Typically investors look at mutual funds from their size (large-cap or mid-cap or small-cap), sector and theme. Of late, however, a new kind of investing style is gaining traction. Factor-based investing has been growing in developed markets. But, it is now seeing a flurry of activity in India. Many asset management companies have launched factor-based schemes over the past year or so.
Factor-based funds are a type of active funds, but they tilt the portfolios towards certain stock characteristics to achieve specific risk and return objectives. For instance, one scheme may be more focused on quality of the stocks, while another may buy stocks based on their recent momentum. Yet another scheme could be investing in stocks focused on value. There are also schemes that are focused on stocks that have low volatility over a period.
There are several factors or investment styles like value (price-to-earnings ratio or price-to-book ratio), quality (strong fundamentals like profitability, management, earnings growth), low volatility, momentum (strong price movement in recent times), size, and dividend yield (good track record of dividends).
You could also have schemes that are based on multiple factors. This is called multi-factor investing, where a fund manager may use a combination of strategies or factors to generate higher risk-adjusted returns.
“From 2013 onwards, the AUM (assets under management) of factor-based funds and ETFs (exchange traded funds) have increased from $150 billion to over $600 billion in the US market. They now account for 21 per cent of the total US ETF market assets, up from just 3 per cent a decade ago. I am expecting a similar growth story to play out for factor-based strategies in the Indian market in the coming decade,” said Mayank Misra, VP (product management) at fintech platform INDmoney.
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What should be noted is that not all factors will perform at the same time. “Growth and momentum factors outperform during bull markets. Value performs best during early recovery following a down market. Quality stocks characterised by strong balance sheets and stable earnings perform well during bear markets as they offer downside protection and do not fall much,” said Misra.
As equity markets scaled new highs last year, many of these momentum funds delivered 40-45 per cent returns. Value funds, on the other hand, on an average returned 35-40 per cent. In the same period, pure Nifty 50 index funds delivered around 24 per cent returns.
Factor funds, however, are not everyone’s cup of tea. “These factors have proven to work across long time periods (over 10 years) but they do not perform equally well across all short-term periods,” said Jiral Mehta, senior research analyst at FundsIndia. “All investment styles go through their cycles and have phases of underperformance followed by significant outperformance and the cycle repeats. In the longer run, the phases of outperformance compensate more than enough for the phases of underperformance.”
Notably, when these factors go out of favour, if you have invested only in one factor, then your entire portfolio might go through prolonged underperformance. “We prefer diversifying based on investment factors, mainly quality, value, blend, mid/small cap and momentum,” said Mehta.
Who should then invest in factor funds?
“If you understand what factor you are investing in and in which market it will outperform and where it will underperform, instead of having vanilla index fund, you can have some factor funds exposure. But, if you are a normal investor and you have a small portfolio, there is already a lot of confusion. So, no need to confuse it further,” said Anant Ladha, founder of Invest Aaj for Kal.
Factor funds can complement traditional market-cap-weighted investments by targeting specific characteristics that may perform better under certain market conditions. “Increasing exposure to growth and momentum factors during bull markets while favouring quality and value factors during bear market phases should lead to overall portfolio outperformance,” said Misra.