For example, someone selecting stocks that are undervalued is investing in value as a factor.
Mainly, there are two kinds of factors: Macroeconomic factors and Style factors. Macroeconomic factors which are not directly correlated with the financial assets yet affect their prices. For instance, GDP growth, Interest rate, Inflation, and so on.
Style factors, on the other hand are directly related to and indicate the risk and returns within the asset classes. Some of the style factors are value, quality, size, momentum, etc.
In factor investing, your portfolio may be constructed based on a single factor or multiple factors. For example, momentum funds include those financial securities which have shown upward price movements in the last six-twelve months.
Here, momentum is a single factor used while constructing a portfolio. You will find many funds based on a single factor like value, momentum, or quality.
An example of multi-factor investing can be a value and low volatility fund, in which only those stocks which are undervalued and have lower variation in the prices over time would be included.
Research also suggests that Warren Buffett’s stock-picking styles can be explained by factors.
Researchers have shown that to duplicate his returns, one can use quality, value and low-volatility factors.
Why is Factor Investing better than Traditional Investing?
Factor investing proves to be a better investment strategy on the following parameters.
The old-school way of building a portfolio of stocks is where fund managers do fundamental research by studying how a specific company is doing compared to its competitors and its management and the reasons why a sector or a company is likely to do well in the future.
Factor investing is a rule-based investment strategy that strategically selects stocks having specific attributes.
For example, a momentum factor fund would rank all the stocks in its universe based on momentum score and then rank the stocks and give them weights, and these weights could be either equal-weighted or weights dependent on its momentum score.
Similarly, in a multi-factor model, all the stocks are ranked based on multiple factors, and a portfolio is constructed. The actual value is created when algorithms can give weights to different factors that are likely to do well in current market scenarios.
Let’s take a look at the factor indices created by NSE. This analysis is from 1st April 2005 to 30 April 2022
We can see that all the factors have been able to beat the index over the last 17 years. Value as a factor has not been too well over 17 years, but over the last year or so, it has done quite well.
Also, if we look at the volatility, which is a measure of risk, all the factors except Value have lower risk than the Nifty50.
In fact, the low volatility factor has the least volatility and even with such a low risk, it has been able to beat the index.
2) Better Transparency
Factor investing provides you with more transparency than traditional investing. In traditional investing, the reason for poor returns or poor performance can be a mystery for you. However, when you have invested in a factor-based fund, you can easily understand the reason for the performance of the fund.
3) Low cost
Factor investing involves codifying the rules and identifying suitable opportunities. Therefore, the fund manager is not required to put much effort into managing the portfolio. Consequently, the cost associated with factor investing is lesser than that of a traditional active investment strategy.
One issue you may have noticed is that when the market is down, your entire portfolio is in red. This is because you are putting all your eggs in one basket.
For example, you have invested only in companies based on market capitalization or specific sectors. Factor investing lands a helping hand here.
When you invest in a multi-factor fund, where factors are less correlated, you end up with a well-diversified portfolio.
Therefore, when one factor is not working, another may work and you may be saved from being a victim of a market fall.
5) Eliminate human bias
One of the problems with traditional investing is the existence of human bias. You may make the decision partially based on your judgment. You may end up investing in poor-performing stock, or you may avoid the stock performing actually well.
Moreover, you may panic when the market is falling or may get lured when the market is going up. This usually happens in traditional investing due to human emotions.
You might argue that investing via mutual funds may eliminate this bias because the fund manager is clear about his investment strategies and goals. We are forgetting that even funds are managed by humans.
No matter how strategic a manager is, there are chances of biases. Factor investing solves this problem by avoiding human bias and qualifying the stocks based on logic.
To wrap up, factor investing is a more objective, systematic, and evident approach to investing. When the traditional investment approach is likely to leave you with market-like returns, lower diversification, and higher risk, factor investing comes to the rescue.
With factor investing, you are more likely to get a diversified portfolio with lower risk exposure and better returns.
(The author is Director (strategy) at Estee Advisors and head of investments at Gulaq, a part of Estee Group)
(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)