What makes Factor Investing unique from the other forms of investing?
Factor Investing: A Smart Combination of Active and Passive Investing
Factor investing is an investment strategy which entails selecting securities based on certain factors or attributes to generate returns that outperform the benchmark while providing lower volatility.
When we are looking at university options for further studies, we evaluate several factors such as its location, faculty, global ranking, career prospects and fees among others. Similarly, while making an investment decision, we need to analyse it from various perspectives and identify the attributes that affect a security's long-term risks and returns. These attributes are called factors.
Factor investing is based on the idea that these factors have a persistent impact on the stock returns and can explain returns across markets, economies, sectors and geographies. In addition, factors are also intuitively sound and must be robust and investable.
Factor investing is a unique confluence of active and passive investment management styles. The inherent rule-based approach of factor investing makes it a disciplined investing technique like passive investing, while the objective to beat the market likens it to traditional active investing.
What are the traditional forms of investing in the Mutual Fund Industry?
Active Mutual Funds - Active mutual funds aim to outperform the benchmarks. They use a wide variety of data, including both quantitative and qualitative research to find the best opportunities. Since active fund managers aim to forecast the future and make subjective bets based on their analysis, such funds tend to be influenced by cognitive and emotional biases.
Passive Mutual Funds - A passive mutual fund replicates an index and aims to just mirror the performance of the index, not outperform it. It is inherently disciplined and since there is no subjective decision making, it is free of cognitive and emotional biases as well.
Why is factor investing better?
Active and Passive investing both have their pros and cons. However, factor investing provides a middle ground between them and a strategy that is unique compared to both. Since factor investing requires choosing securities based on specific rules and parameters which are associated with higher returns, it has the capability of outperforming the benchmark in the long run. At the same time, being based on rules, it is inherently disciplined and protected from cognitive and emotional biases.
Four factors have emerged as ones that can play a significant role in the risk and returns generated by stocks. These are Quality, Low volatility, Momentum and Value. To understand their contribution better, one can think of them in the context of our Indian Cricket Team. While Sachin’s quality batting and master strokes are the first ones to come to mind, this alone is not enough to win a match. For winning a match it's the team efforts that matter. With Dhoni’s low-volatility advice, Sehwag’s scoring momentum and Dravid’s valuable “wall” for a victory along with Sachin’s quality batting, a dream team can be created.
Similarly, we can create such a “Dream Team” of factors when we look at our investing style. For a detailed explanation of how these work, please read our factor book and watch our factor talk series.
Benefits of Factor Investing
- Diversification - “Diversification is the only free lunch” - Harry Markowitz. Diversification is achieved by investing in securities that behave differently compared to each other. Since factor investing is so distinct from other forms of investing, it often produces portfolios that behave differently compared to the others as well. Along with this external diversification, it can provide internal diversification as well by using uncorrelated factors investing provides the benefits of diversification. Analysis has proved that diversification yields the most cost-effective level of risk elimination.
- Elimination of human bias - Factor investing is based on rules. It involves strategically choosing securities from a universe based on certain quantifiable parameters. This does not allow room for any kind of discretion and consequently there is no room for biases. Every security selected has a strong logical backing based on rules. The systematic nature of factor investing brings discipline in security selection making the fund more unique as compared to active or passive funds.
- Backtesting - Backtesting refers to the process using historical data to test an investment strategy or a model. This allows the fund manager to evaluate the performance of a strategy over a long period of time which can provide a more accurate picture of its future prospects. Backtesting allows a strategy to be stress tested under different market conditions and scenarios which can help identify potential weakness, strengths, threats and opportunities. With this information, adjustments can be made to their strategy to better withstand extreme market conditions. Backtesting a portfolio strategy is extremely difficult in case of active mutual funds since they tend to make subjective investment calls. However, it is possible for factor based mutual funds since they are created on predefined rules.
- Technological Backing - Today’s business world is dynamic and is changing at a very fast pace from time to time. Technology has replaced many roles and data now explains more and more of the alpha generated by active managers. In such an environment, it is important to adopt the use of technology in making investment decisions too.
Conclusion :
Over the period of the last 10 years, the underperformance rate of Indian equity large-cap active fund managers was a whopping 67.4% (S&P Indices Versus Active (SPIVA) Funds Report - Indian Scorecard, 2022). The underperformance rate of Indian ELSS funds for the last 10-year period has been 63.9% (SPIVA - Indian Scorecard, 2022). With such a high rate of underperformance, it becomes necessary to look at a different strategy to outperform the market. Factor investing can be thought of as an efficient mix of active and passive investing. It has the potential to outperform the market while providing the benefits of diversification. Furthermore, analysing the trends in the foreign markets, factor investing seems to be a promising bet to generate high risk-adjusted returns in the long run
Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
Bibliography:
Spiva® India mid-year 2022, S&P Dow Jones Indices. Available at: https://www.spglobal.com/spdji/en/spiva/article/spiva-india/ (Accessed: February 9, 2023).