Factor Investing: The Five Pillars of Financial Growth

• Date : August 30,2024

In the ever-evolving world of investing, a growing number of investors find factor investing an efficient strategic approach to increase returns and manage risk in a better way. This empirical and quantitative methodology focuses on certain characteristics or factors that have historically led to outperformance in the market. For any investor, understanding the concept of factors is essential to acknowledge the sources of risks and returns of different securities effectively.

Know More About Factor Investing

Factor investing is an investment style based on the identification and monetization of factors, which have traditionally, through history, given a risk premium over the market. The factors may be as simple as valuation metrics or as complex as market behaviour indicators and company fundamentals. Conventional investing approaches mainly revolve around asset allocation and timing the markets, while factor investing systematically captures such premiums.

Factor investing bridges the gap between active and passive investing, offering a systematic and data-driven approach to portfolio construction. Finding the underlying drivers of returns that can endure in various market circumstances is the primary goal of factor investing. With this method, investors can build portfolios that could outperform over the long run and are more immune to market swings. 

Understanding Factor Investing

Think of yourself as a chef preparing gourmet meals. Instead of relying upon any one ingredient, you select particular ingredients (factors) that will help the taste, texture, and overall presentation explode with flavour. Just as different ingredients bring something unique into the mix, multiple factors bring something special to the mix of an investment portfolio. 

For instance, you would pick fresh herbs for their aroma (quality), aged cheese for its mouthfeel (value), seasonal vegetables for their peak taste (momentum), and a workhorse staple such as rice for its consistency (low volatility). You put these together in a thoughtful combination and arrive at a tasty, balanced meal. In the same way, combining different factors in factor investing can lead to a well-rounded and potentially more successful investment portfolio.

Types of Factors

Factors can be broadly classified into macroeconomic factors—these refer to broad economic trends and conditions that impact markets and style factors that relate to specific attributes of securities that help explain their returns and risk characteristics. Below are few of the prominent factors:

• Quality Factor:

  Quality factor investing focuses on fundamentally strong companies that consistently reflect positive earnings, have healthy balance sheets, and are profitable even in seemingly tough market periods. Such companies display less vulnerability during economic declines and are usually less volatile than their industry peers. Common parameters used to define quality are Return on Equity (ROE), ROE consistency, Dividend Payout Ratio, Debt-to-Equity, and Current Ratio.

• Low Volatility Factor: 

  When investors incorporate the low volatility factor investing approach, they search for stocks or assets exhibiting price volatility less than that prevailing in the overall market. These stocks are considered more stable and hence do not display high price movements, appealing to investors who are risk averse and prefer a smoother return over time. Measuring volatility through annualised standard deviation of returns, beta, and semi-deviation is a common practice. 

• Momentum Factor: 

  Momentum factor investing strategy capitalises on securities that have been performing well in the recent past and are anticipated to continue to exhibit similar performance in the near future. This strategy relies on market psychology, driven by phenomena like FOMO and herding behaviour, to benefit from the ongoing trends. By recognizing these patterns and riding the wave of winning stocks, momentum investing enhances the potential for financial growth.

• Value Factor: 

  Value factor investing focuses on investing in stocks that are perceived to be undervalued relative to their intrinsic value, often measured by price-to-earnings (P/E) multiple, price/earnings-to-growth (PEG) ratio, and dividend yield. In view of this, investors applying the value factor hope that these underpriced securities will gain in price over time when the market acknowledges its real value.

• Multi-factor:

  Multi-factor investing is a strategy that involves choosing securities based on various factors that are believed to generate higher returns. Instead of relying on a single factor, multi-factor investing includes a combination of several characteristics that have historically been associated with higher risk-adjusted returns.

Performance of Factor Indices in the Global Market

Source: Internal research, Bloomberg, NJ’s Smart Beta Platform (in-house proprietary model of NJAMC). This chart depicts the growth in the NAVs of S&P’s factor based indices vis-a-vis that of the S&P 500 Index over the period 5th July 1995 to 31st July 2024. All the NAVs are in USD and have not been converted to INR. All the indices have been scaled to 1,000 as of 5th July 1995. Past performance may or may not be sustained in future and is not an indication of future return.

Point-to-Point Return of Global Indices

10-Year Rolling Return of Global Indices

Source: Internal research, Bloomberg, NJ’s Smart Beta Platform (in-house proprietary model of NJAMC). Data for the period 5th July 1995 to 31st July 2024. Mean Return (%) and Median Return (%) represent the average and median values of the daily rolling returns for each of the indices mentioned above, respectively. Past performance may or may not be sustained in future and is not an indication of future return.

Performance of NJ Factor Model

Past performance may or may not be sustained in future and is not an indication of future return. The above is only for illustration purposes and should not be construed as indicative return of offering of NJ Asset Management Private Limited.

Source: Internal research, Bloomberg, CMIE, National Stock Exchange NJ’s Smart Beta Platform (in-house proprietary model of NJAMC). Calculations are for the period 30th September 2006 to 31st July 2024. NJ Traditional Value Model, NJ Enhanced Value Model, NJ Quality+ Model, NJ Momentum+ Model, NJ Low Volatility+ Model and NJ Multi-Factor+ Model are in-house proprietary methodologies developed by NJ Asset Management Private Limited. The methodologies will keep evolving with new insight based on the ongoing research and will be updated accordingly from time to time.

Point-to-Point Return of NJ Factor Model

10-Year Rolling Return of NJ Factor Model

Past performance may or may not be sustained in future and is not an indication of future return. The above is only for illustration purposes and should not be construed as indicative return of offering of NJ Asset Management Private Limited.

Source: Internal research, Bloomberg, CMIE, National Stock Exchange, NJ’s Smart Beta Platform (in-house proprietary model of NJAMC). Data for the period 5th July 1995 to 31st July 2024. Mean Return (%) and Median Return (%) represent the average and median values of the daily rolling returns for each of the indices mentioned above, respectively. Past performance may or may not be sustained in future and is not an indication of future return.

Benefits of Factor Investing 

• Better Risk-adjusted returns: By incorporating factors that historically contribute to higher returns, investors can potentially outperform broad market indices.
• Transparency: The systematic and rule-based approach of factor investing provides transparency in investment decisions, making it easier for investors to understand the rationale behind their portfolio construction.
• Diversification: Depending on their investing objectives and risk tolerance, investors can make changes to their portfolios to highlight specific characteristics.
• Unbiased decision-making: Factor investing involves rule-based decision-making based on specific factors, reducing the influence of personal biases and emotions.

NJ Asset Management Company (NJ AMC) provides factor-based investment solutions that are unique and supported by quantitative evidence. NJ AMC’s commitment to rule-based and factor investing highlights the dedication to tailoring strategies according to the client’s investment goals and risk profiles. For a deeper understanding of factor investing, investors can explore the NJ’s Factor Book—an insightful coffee-table book designed to guide you through our innovative factor-based investment philosophy.

The Future of Factor Investing

The future trends in factor investing will undoubtedly open new opportunities because of technological development and changing market trends. Advancements in artificial intelligence will help refine factor models and enhance predictive accuracy. 

Conclusion

Factor investing is a powerful and sophisticated management style that integrates the best characteristics of active and passive strategies. Investors can construct a robust portfolio based on quality, low volatility, momentum, and value factors that will enable them to effectively navigate through different market environments. 

By understanding and focusing on certain factors, investors can also aim to generate better risk-adjusted returns, effectively manage risks, and potentially attain their financial goals more confidently. As the investment landscape continues to evolve, factor investing will continue to be a vital investment strategy. Whether you are an experienced investor or an emerging one, factor investing can give you quite a substantial advantage in your quest for financial success.

FAQs

1. What is the difference between factor-based investment and traditional investment strategy?

By using factor-based investment, investors seek to improve risk-adjusted returns. It involves the implementation of quantifiable concepts including value, momentum, quality, and volatility. On the other hand, traditional investing comprises either passive management using index funds or active management, where investors choose stocks based on a combination of qualitative and quantitative research.

2. What are the benefits of factor investing?

A few advantages of factor investing include focusing on factors that have historically generated positive returns, diversifying investments across a range of market situations, and increasing risk management by utilising systematic rule-based strategies.

3. What are the risks associated with a factor investing strategy?

The potential underperformance of particular factors, concentration risk, and dependence on the accuracy of factor models are among the risks connected with factor-based investment.

Investors are requested to take advice from their financial/ tax advisor before making an investment decision.

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