A Deep Dive Into Factor Investing

Over the last one year the Indian stock markets have displayed strength and resilience by outperforming all the major global equity markets. Concurrently, factor investing has been thrust into the limelight and is gaining traction among investors. In this special feature, Armaan Madhani helps us delve deep to understand factor investing and explore its history, pros, cons and historical performance in the Indian as well as global capital markets 

BlackRock Inc., an American multi-national investment company, is a leader in factor investing that launched the first factor fund in 1971 and has been driving innovation in the category for over 40 years. As per BlackRock, 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 identify the characteristics they look for in security.[EasyDNNnews:PaidContentStart]

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 have historically been associated with an asset’s returns – macroeconomic and style factors. These factors are drivers of returns that impact the returns of assets across different asset classes. Style factors are factors that explain risks and returns within each asset class, whereas macroeconomic factors are factors that explain risks across multiple asset classes. Some common macroeconomic factors include the rate of inflation, GDP growth, political risk, sovereign risk and the unemployment rate. 

Common style factors encompass growth versus value stocks, size, volatility, momentum, quality and dividend yield. These attributes are readily available for most securities and are listed on popular stock research websites. Factors are usually combined together to build portfolios that are expected to generate excess returns against their benchmarks. Also, these factors are used to manage risks within the asset classes. To quote Bijon Pani, Chief Investment Officer, NJ Asset Management, from an interview published in an earlier issue of DSIJ Magazine (Volume 37, Issue 23), “Factor investing involves taking exposure to risk-adjusted return premiums that can be harvested over the medium to long term.” 

“The most commonly used factors are value, quality, momentum, low volatility and size. These premiums exist due to either strong economic rationale or behavioural anomalies. The value factor is an example of the former and involves buying stocks for cheaper than their intrinsic value and making a return when these stocks appreciate. Momentum factor premiums are behavioural in nature and signify the persistence of stocks with strong price momentum in upward or downward trend. Even though factor premiums can deliver high riskadjusted returns, they are susceptible to cyclicality in their returns in the short term due to various reasons.” 

“Value stocks may not do as good as growth stocks when the economy is booming and rates are very low with easy credit availability as was the case in the recent past. Factor premiums also tend to have low or negative correlation to each other. So, combining two or more factors in a multi-factor approach provides a smoother risk-adjusted performance through the benefit of diversification. Using global data, many factors have been back-tested over a 100-year period to show the persistence of these premiums over various business cycles and macro events. This consistency gives investors extra comfort as they know that the strategy works over the long term and is a powerful risk-adjusted concept for wealth creation,” he further said. 

History of Factor Investing

The seeds of factor investing were sown in the 1960s when the capital asset pricing model (CAPM) was first introduced. The theory strived to explain an asset’s returns relative to its sensitivity to market risk. Although the CAPM helped provide a framework for pricing assets, empirical research provided evidence that stock market returns did not exactly follow the model’s framework. Instead, there was evidence that stock market returns were correlated to the stock’s characteristics. One of the earliest observations was that the size of a company’s market capitalisation and investment style (growth or value) are paramount considerations for investors. Small-Cap and value stocks usually perform better than Large-Cap and growth stocks. 

This explains the performance of stock returns that deviate away from the explanations provided by the CAPM. As per a research paper by Fidelity Investments, investors seeking returns in excess of the market may consider exposure to other factors (or betas) that have exhibited long-term outperformance: ‘smart’ or ‘strategic’ betas. Investment managers—quantitative investors in particular—have employed these factors over the years to build and enhance their portfolios. Once the relevant factors that drive return and risk are identified, exposures can be measured on an ongoing basis to ensure a portfolio is best structured to take advantage of these factors. Fundamental investors also use factors widely, either as a means to generate new stock ideas or to monitor intended or unintended exposures in their funds. 

Common Style Factors 

◼ Size 

Investors can capture size by looking at the market capitalisation of a company. Market capitalisation is 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 or earning potential is higher as compared to large-cap companies. Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. 

◼ Quality 

The quality factor of a company can be captured using diverse fundamental ratios calculated using financial statements, such as return on equity (ROE), return on assets (ROA), gross margin, EPS growth and debt to equity, to name a few. In essence, investors want to invest in a company that is financially healthy. High-quality companies can be defined by characteristics such as strong corporate governance, high ROE, low debt, high liquidity, stable earnings, consistent asset growth and healthy free cash flows. Typically, rational investors would be willing to pay a premium for stocks that possess high-quality businesses with many of the above-mentioned characteristics. This denotes the potential of high-quality stocks to outperform their lower quality peers in the long run. 

◼ Value 

The value factor aims to capture excess returns from undervalued stocks that are currently trading at low prices relative to their fundamental value. Value stocks are usually large-cap and well-established companies that are currently trading below their real worth (i.e. intrinsic value) and will thus provide superior returns. It is often measured using the priceto- earnings ratio, price-to-book value ratio, price-to-sales ratio, dividend yield ratio, etc.

◼ Momentum 

Momentum investing is a type of factor investment strategy which aims to purchase financial assets such as stocks, bonds, commodities or derivatives that have been exhibiting an upward price trend or short-sell securities that display a downward price trend. In essence, the strategy states that stocks with high returns in past periods due to improving financials or high growth tend to have high returns in the coming future periods and stocks with low returns tend to have low returns in the future. Keep in mind the age-old adage: ‘the trend is your friend’. The objective is to take advantage of market volatility by discovering investment opportunities in the short or medium term price trends of securities. 

◼ Volatility 

Volatility as a factor is usually measured using common statistical tools like standard deviation, beta or semi-variance. The low volatility factor targets securities with lower volatility characteristics. This typically translates into generally more consistent returns with lower deviations from long-term means. Several studies, including those conducted by Haugen and Heins (1972) as well as Frazzini and Pedersen (2014), have demonstrated the existence of the low volatility effect with empirical evidence of the ability of low volatility stocks to generate better risk-adjusted returns versus high volatility stocks on average, in the US, European as well as emerging markets. 

Pros of Factor Investing 

The factor investing strategy makes decisions based on evidence or metric of performance of securities based on certain factors. Therefore, it is a more reliable strategy for investing. Also, investors choose securities based on a factor but also monitor their performance and make changes if needed. Hence, factor investing combines the benefits of active and passive investing, thereby furnishing investors with the best of both worlds. Investors should make sure that the factors they choose must have low or minimal correlation. If one can create an investment portfolio based on different factors, then it will have low volatility and high diversification, which minimises a portfolio’s exposure to risk. 

Cons of Factor Investing 

Factor investing is a long-term investment strategy. Therefore, outperformance cannot be expected over periods of less than a year, preferably even longer. The factor investing strategy does not guarantee returns. There can be cyclical returns as all factors cannot function the same way at all times. For instance, when interest rates are low, many factor-based funds tend to underperform. In such a situation, it isn’t easy to understand whether the underperformance is temporary or permanent. At times, investors may accidentally expose themselves to additional risks instead of minimising the risks. 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. In addition, using only one factor for the investment strategy may impose multiple risks. 

Historical Performance of Factor Investing

Let’s take a look at the historical performance of factor indices created by the NSE. This analysis is from April 1, 2005 to April 30, 2022. It is distinct that almost all the factors have been able to outperform the frontline Nifty 50 index over the last 17 years. Also, if we look at the volatility, which is a measure of risk, all the factors except value have lower risk than Nifty 50. 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.

A similar outperformance can be witnessed when we compare performance of the US-based S and P 500 index versus other factor-based indices.

Rise of Factor-Based Strategies Globally 

According to a survey conducted by FTSE Russell in 2019 to evaluate the prevalence of smart beta and factor-based strategies among 178 asset managers spanning across various AUM tiers and regions, over 58 per cent of the respondents have adopted smart beta strategies in their portfolios. In addition, among those who were still evaluating such strategies, more than half indicated plans of incorporating them in their portfolios within the next 18 months. Interestingly, the growth of multi-factor smart beta strategies has been especially dominant with 71 per cent of managers using multi-factor strategies in 2019 as opposed to 49 per cent in 2018. It is also worth noting that over 60 per cent of the surveyed respondents have adopted smart beta strategies to make long-term strategic allocations as opposed to a mere 7 per cent asset managers that primarily use smart beta for short-term tactical purposes.

Guide to Factor Investing 

Factors can help investors build portfolios that better suits their individual needs; just as knowing the nutrients in your food can help your body perform better. Similarly, investors looking for downside protection in a volatile market environment might add exposure to minimum volatility strategies to seek reduced risk, while Investors who are comfortable accepting increased risk might look to more return-seeking strategies like momentum. Factor-based investing strategies focused on specific factors or even multi-factor strategies are easily available for investment via several open-ended mutual fund schemes as well as low-cost ETFs. 

Also, retail investors who are skilful at portfolio management and confident of their equity research ability can create portfolios by choosing to focus on peculiar factors or themes such as small-cap high-growth stocks or large-cap value stocks and invest in a systematic manner. Below is a list of popular factor based/smart beta ETFs in India. 

Conclusion 

The factor investing strategy is designed to enhance diversification, generate above-market returns and manage risk. Portfolio diversification has long been a popular safety tactic, but the gains of diversification are lost if the chosen securities move in lockstep with the broader market. The good news is that factor investing can offset potential risks by targeting broad, persistent and long recognised drivers of returns. Extensive research, including that of Nobel Prize winners, has proven that certain factors have driven returns for decades. These factors have generated returns due to the following three reasons: an investor’s willingness to take on risk, structural impediments and the fact that not all investors are perfectly rational all the time. 

Advancements in technology and data allow investors to take advantage of these time-tested ideas in new ways, from smart beta to enhanced factor strategies. Smart beta strategies target factors using a rules-based approach, usually with the goal of outperforming a market-cap-weighted benchmark. Smart beta strategies are now widely available in ETFs and mutual funds, making factor strategies affordable and accessible to every investor. Enhanced strategies use factors in more advanced ways – trading across multiple asset classes, sometimes investing both long and short. Investors use these enhanced factor strategies to seek absolute returns or to complement traditional active investment strategies. 

[EasyDNNnews:PaidContentEnd] [EasyDNNnews:UnPaidContentStart]

[EasyDNNnews:UnPaidContentEnd]