Mutual funds have become an ideal form of investment where investors need not worry about selecting stocks or assets to maximise wealth. Investors have to simply select a mutual fund scheme and invest in it. However, there are certain costs associated with mutual fund investment. But was it so simple to pick target investments while balancing the risk and return parameters which can lead to maximising wealth? This is where the concept of factor investing arises in mutual funds. In this article, we will discuss in detail about factor investing.
What is Factor Investing?
The concept of factor investing is an investment strategy used to select assets based on a specific set of attributes and factors. In simple words, this strategy can also be referred to as a combination of active and passive investment strategies. Investors who want to follow factor investing shall identify the characteristics they look for in security. These characteristics are what investors believe in and will indicate the security’s success in providing better returns, diversification and reduced risk.
There are two main types of factors that are associated with a fund’s returns – style and macroeconomic factors. These factors are drivers of returns that have an overall impact on different asset classes. The style factors explain the risk and returns within each asset class, while macroeconomic factors explain the risk across multiple asset classes. Therefore, factor investing uses these parameters to form a portfolio and convert it into an algorithm or technique to select funds and avoid funds that do not meet these parameters.
Factors are usually combined together to build portfolios that are expected to generate excess returns against their benchmark. Also, these factors are used to manage risks within the asset classes. Therefore, this strategy focuses on specific companies as well as captures the broad risk across markets.
What are the Types of Factor Investing?
The two types of factors used under this strategy are macroeconomic factors and style. Let’s discuss them in detail below –
These are the broad factors that have an overall impact across asset classes. Some of the macroeconomic factors are –
1. Economic Growth
If the economy is growing, there is a more likely increase in company profits as there is a rise in consumer spending. Thus, this also improves the stock market performance. On the other hand, a downturn in the economy leads to a difficult situation for a company to earn profits. As a result, there is a decline in company stock prices.
Inflation impacts the purchasing power of consumers and their ability to spend on things. A rising inflation will increase the cost of goods. At the same time curtails the purchasing power of consumers if the income growth is not able to beat inflation. Also, this will impact the businesses and adversely affect the stock prices.
3. Interest rate changes
An increase in interest rates in the economy will prevent businesses and individuals from borrowing money or taking a loan from the bank. This will impact the purchasing power of individuals and slow down economic activity.
The credit risk is the risk that investors take by investing in companies rather than government bonds. Also, investors are compensated with higher returns for the risk taken. However, companies and their securities have a varying degree of default risk. Therefore, investors must carefully choose these securities with the amount of risk they prefer.
The style factors are the intrinsic factors of a stock that directly impact the stock performance. Some of the style factors are –
1. Company Size
The company size and market capitalisation are used to determine whether it can be classified as a small cap, mid cap or large cap company. This strategy focuses on small-cap companies because, historically, the growth/earning potential is higher than the large-cap companies.
2. Value Approach
The value investing approach involves selecting undervalued stocks using fundamental analysis. It is often measured using the price to earnings ratio, Price-to-book value ratio, Price-to-sales ratio, dividend yield ratio, etc.
This factor focuses on stocks that have strong and positive results. The idea is that these stocks will continue to provide an upward trend in prices in future and attract attention to invest in such stocks. In particular, momentum strategy looks at a stock’s short-term returns, usually between three months to one year. It can be measured using point-to-point past returns, historical alpha, etc.
One of the crucial factors for analysis is the quality of stocks and companies. This factor focuses on financially healthy companies with a low debt to equity ratio, high return on equity, high return on assets, good quality of management, etc.
Empirical evidence suggests that stocks with lower fluctuations in their stock prices tend to outperform the stocks with higher fluctuations. It can be measured using standard deviation and beta.
6. Dividend Yield
This factor helps to identify stocks with higher than average and growing dividend yields that tend to outperform stocks with low dividend yields.
Factor Investing in Mutual Funds
Factors like size, volatility and momentum are easier to grasp and consistently applied across mutual funds. Other factors like value and quality are subject to more research where other variables are required to demonstrate these factors. Different financial ratios are applied and tested to evaluate the effectiveness of these factors in different investment models. Most popular funds with this strategy having a single factor approach are –
- Momentum Based Fund – UTI Nifty 200 Momentum 30 Index Fund
- Quality Based Fund – SBI Nifty 200 Quality30 ETF
- Value Based Fund – Kotak Nifty50 Value20 ETF
However, an advanced approach to multi-factor models is also gaining popularity. This approach seeks to combine two or more factors to deliver risk-adjusted returns consistently. Some of the popular funds with strategy are –
Another emerging trend for factor investing is its application to multi-asset funds. In India, where the focus on risk is increasing, low-risk hybrid products are considered like balanced advantage funds, aggressive hybrid funds and multi-asset allocation funds. Therefore, the focus on macroeconomic factors is increasing to generate portfolio models that bring more science to decision-making. This will help for portfolio allocation to different asset classes instead of a traditional approach.
Advantages and Disadvantages of Factor Investing
The following are the advantages of factor investing –
- Evidence-based Investing: Many investors make guesses about the direction of stock price and invest accordingly. However, this strategy makes decisions based on evidence or metric of performance of securities based on certain factors. Therefore, this is a more reliable strategy for investing.
- Diversification: Through this strategy, investors can capture stocks which may be ignored due to human bias in a traditional investment portfolio. The different factors can improve diversification because style and macroeconomic factors cover various situations in an economic cycle. Therefore, this minimises the overall portfolio risk in the long term.
- Reduces Volatility: The investment factors have a low correlation with one another. Since investment decisions are made on various factors, it helps to filter stocks based on investment objectives. Therefore, it allows higher diversification in the portfolio.
- Cost Effective: This strategy requires fewer analysts than a traditional actively managed portfolio. Therefore, this approach is less expensive than other investing strategies.
The following are the disadvantages of factor investing –
- Risk: Sometimes, investors may accidentally expose themselves to additional risks instead of minimising them using this strategy. For instance, investors using the size factor may put too much weight towards small-cap stocks. It exposes them to risks associated with small, high-growth companies. Moreover, using only one factor for the investment strategy may impose many risks.
- Long-Term Strategy: This is a long-term investment strategy. The outperformance cannot be expected over periods of less than a year, preferable even longer.
- Returns: The factor investing strategy does not guarantee returns. There can be cyclical returns as all factors cannot function the same at all times. For instance, when interest rates are low, many factors funds tend to underperform. At this stage, it isn’t easy to understand whether the underperformance is temporary or permanent.
Even though factor investing has its own risks and demerits, it provides a modern and more scientifically proven approach for managing portfolios. In other words, it provides another way to approach investing for long-term investors. It can be used as a complementary strategy to reduce volatility while investing for long-term outperformance.