How can investors benefit from Factor Investing

There are several ways in which an investor can take exposure to equities today. While passive investing is gathering steam, within this universe, investors are increasingly considering strategies that move beyond the market capitalisation-based ETFs and index funds. This is where factor investing comes in. Compared to global markets, factor-based investing is relatively new in India.

What is Factor Investing?
Factor investing involves targeting specific drivers that have the potential to offer you better returns. Going deeper into the strategy, there are two main types of factors. One is fundamental-based factors, and the other is price-based factors. The current popular offerings include factors like low volatility, momentum, value, dividend yield and quality, to name a few.

In a factor-based portfolio, from within the investable universe, stocks that exhibit the factor characteristic will be chosen, and the basis of certain parameter weights will be assigned. For example, let us consider the case of a value factor based.

The names which will form a part of this portfolio will be value companies from a chosen universe. The universe under consideration here can be Nifty50 or Nifty500 names depending on the nature of the product. In the case of the Nifty 50 Value 20 Index, the 20 companies which make up the portfolio are selected from the Nifty50 universe basis of Return on Capital Employed, Price-Earnings, Price to Book Value and Dividend yield.

Single Factor or Multi-Factor?
Long-term performance data indicates that single-factor-based index strategies could exhibit cyclicality and might underperform during certain market phases. For example, a momentum-oriented strategy will not perform well in all phases of a market cycle. As a means to circumvent the cyclicality impact, there are multi-factor strategies available.

In a multi-factor offering, the approach is to select stocks based on a combination of multiple factors. For example -- the Nifty Alpha Low Volatility 30 Index. As the name suggests, the portfolio of stocks selected here will be based on two factors- Alpha and Low volatility. The stocks here will be selected from the Nifty 100 and Nifty Midcap 50. In effect, through a single index or an ETF, an investor gets the opportunity to take exposure to multiple factors.

Benefits of Factor Investing
Factor-based investing combines both active and passive fund management strategies. The underlying index of a factor-based product is actively managed basis on the factor chosen. Thereafter, investors have the option of investing in such an index through ETFs in a passive manner. Since the entire process the rule-based, there is no room for human bias while making investment decisions.

Also, the underlying index is not static as these get reviewed semi-annually to keep up with the evolving market conditions. Hence, an investor need not worry about rebalancing.

From an investment perspective, some major benefits of utilising the factor investing method include the possibility of improved outcomes, the ability to manage volatility in a healthy manner and the potential for increased diversification, given that factor investing does not involve parking your funds in a singular theme or market capitalisation category.

Factor-based ETFs can be considered by any investor looking to make an equity allocation in their portfolio. In this manner, investors can combine the benefits of both passive and active investment strategies while being a relatively low-cost way to get some exposure to quasi-actively managed funds.

To conclude, if you are an investor looking to build a diversified portfolio, then factor-based ETFs can be helpful.

Depending on one’s portfolio requirement, an investor can choose between a single-factor or multi-factor ETF to invest in. Data indicates that over the long term, factor-based strategies have delivered a positive investment experience.

(Chintan Haria is the Head – Product Development & Strategy at ICICI Prudential AMC)