Everything to Know About Factor Investing in Mutual Funds

The perfect diet for you is one that is customized as per your nutritional requirements. Similarly, when you invest, you should ideally focus on strategies and assets that satisfy the factors critical to your investment journey. The factor-based investing model is something similar.While factor investing has been around for a long time, it is only in the last few years that it has gained widespread popularity in India. The launch of smart beta mutual funds has played a critical role in making it a sought-after investment strategy among investors wanting to generate higher returns at reduced risk.Here’s everything you should know about factor investing-

In factor investing, securities are chosen based on factors or attributes with the potential to generate higher returns. For instance, value-based investing is a subset of factor investing wherein stocks with low company valuations are selected for the portfolio. Here, “value” is used as the factor for selecting the stocks.All of the factors used in this investment model can be broadly classified into macroeconomic and style factors. Broader risks in asset classes such as inflation, economic growth, liquidity, credit, etc. are considered macroeconomic factors. On the other hand, style factors like value, volatility, quality, momentum, etc. are related to risks within an asset class.

While the factor investing model comprises several factors, here is a quick overview of some of the most common ones-

Value-

Cheaper stocks with solid fundamentals have historically delivered higher returns than more expensive ones.

Company Size-

When compared as per their market capitalization, smaller companies prove to be more rewarding in the longer run.

Quality-

If the profitability characteristics of a company are strong, then the stock can outperform stocks of already established and profitable companies.

Dividend Yield-

If the dividend yield of a stock is growing and higher than the sector average, then it can outperform stocks with lower yield over the long term.

Momentum-

If the stock has witnessed strong growth in the last few quarters, then it can continue to outperform in the next few quarters.

Volatility-

Low volatility stocks have historically proven to outperform high volatility stocks.A factor investing strategy can either choose a single factor or create a basket of securities based on multiple factors.

Some of the top reasons to consider the factor investing approach are as follows-

Combination of Passive and Active Investing

Factor investing can be considered a combination of active and passive investing as the factor or formula for selecting securities is fixed. A fund manager is only responsible for building and managing the portfolio as per the selected factor/s.

Evidence-Based Investing

Active investing requires investors to shoot in the dark, hoping it will hit the bullseye. On the other hand, factor investing is more objective and evidencebased. The past performance of securities is thoroughly analyzed with reference to the selected factors.

Lower Investment Cost

While factor-based investing is more expensive than pure passive investing, it tends to be less expensive than active investing. Combined with the higher returns potential, it is a highly cost-effective investment strategy.

Reduced Volatility

Diversification is critical for long-term wealth creation. As the factors commonly used in this strategy have minimal correlation, they help reduce portfolio volatility and offer diversification benefits. Investing in a few different factor-based or smart beta funds is an excellent way to build a diversified basket of stocks.

If you are new to factor investing, then you can select a single factor or attribute to compare top stocks for your investment. You can be overweight on stocks that rank higher on your list and underweight on those ranked lower. With time, you can consider multiple factors to build a diversified portfolio.Alternatively, you can also invest in smart beta mutual funds that follow the same factor-based investment strategy. These schemes track an index but select stocks based on the attributes chosen for their fund. But as you are new to this investment approach, it’d help if you consult an investment advisor before making any decision.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.