Factor investing (FI) is a strategy increasingly adopted by investors as a third style of investing, in addition to active and passive investing. It seeks to combine the advantages of active and passive investment strategies. The objective is to obtain alpha (excess return of an investment over the return of a benchmark index) and increase diversification at a lower cost than traditional active management, although slightly higher than the simple index investing.
The problems inherent in both actively and passively managed strategies have been instrumental in the rise of FI. Actively managed strategies are generally based on an allocation of conviction, sometimes leading to bias; and they attract higher fees than passive investing in their pursuit of above benchmark returns. However, in the recent past, most actively managed large cap funds have struggled to outperform the benchmark. Investing in the Nifty 50 index fund, or ETF, is an example of a passive strategy, in which you can never outperform the Nifty 50 index because of expenses. The FI offers the benefits of active and passive investing as it aims for a transparent, low-cost framework, with a quest to generate higher returns.
Much research has already been done on this strategy globally; over 300 factors have been identified and their performance has been monitored for decades. Simply put, a factor is any characteristic that explains the risk and return of a group of securities. There may be one or more factors necessary to analyze, explain and develop investment strategies.
Some common simple factors are quality, value, alpha, and low volatility. A combination of two or more factors results in multiple factors such as low grade volatility and low alpha grade volatility. As Andrew Ang, a pioneering factor investing scholar at Columbia University, put it, “Just as’ eating well ‘requires you to look at food labels to understand nutrient content,’ invest well. Means examining the labels of the underlying risk factor classes. It’s the nutrients in food that matter. Likewise, it’s the factors that count, not the asset labels. “
There are different approaches to using factors in an investment strategy, commonly referred to as “smart beta,” which has gained popularity in recent years. Smart Beta is a simple and transparent form of FI. The growth of smart beta stems from two main sources: dissatisfaction with traditional active strategies and evidence that simple rules-based approaches can outperform market-cap-weighted indices.
Around the world, FI has rapidly grown in popularity in segments ranging from large institutional investors to sophisticated high and high net worth individuals, family offices and retail investors. Smart beta funds are the most popular around the world with $ 1.12 trillion (approx. ₹83 trillion) of investments, according to the ETFGI report of March 2021 on the ETF and ETP Smart Beta industry landscape. ETFs are exchange traded funds and ETPs are exchange traded products.
A factor helps identify a basket of stocks based on risk-return appetite and preferred investment style. Different factors present strengths and weaknesses in different economic and market environments. Factor indices have generated amazing returns, outperforming broad indices across time horizons and economic cycles. The Nifty Alpha 50 has consistently performed well over various up cycles, followed by the Nifty 200 Momentum 30. During down cycles, the Nifty Low Volatility 50 has performed well, followed by the Nifty 200 Quality 30.
With this, it can be clearly said that FI has really arrived and is going to be an important investment strategy for everyone. And its acceptance is only expected to increase over time and will see greater and broader participation from institutional investors and high net worth individuals to retail investors.
Prashant Joshi is co-founder of Fintrust Advisors.
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