One of our new generation investors wanted to know what I felt about Factor Investing (Smart Beta Investing)and its sustainability in the Indian market. Before sharing my response at the conclusion of this column, let us first take a deep dive into the concept and modus operandi of Factor Investing.
Factor Investing funds that are offered to investors by Mutual Fund houses use specific ‘factors’ while making investments. Factor Investing funds use data and research to build a portfolio based on specific characteristics or factors in stocks that have historically optimised performance while lowering risk. These factors can include value, momentum, quality, volatility and size.
Factor investing is not exactly a new concept worldwide. Institutional investors and hedge funds have been using these strategies for decades. But these techniques have become more accessible to everyday investors through mutual funds and exchange-traded funds (ETFs). These funds use algorithms and historical data to create rule-based investment models. This makes the process more systematic and reduces the need for active decision-making based on predictions or emotions.
In India, factor investing funds are still a relatively novel concept but it is gradually gaining interest. Several fund houses have launched products that follow single-factor or multi-factor strategies. A single-factor fund focuses on just one characteristic, like value or quality, while a multi-factor fund combines two or more factors. The aim of multi-factor funds is to balance out the risks of any one factor underperforming.
Another key benefit of factor investing is transparency. Since the fund follows a rule-based approach, investors have a better idea of how their money is being managed. This is different from traditional active funds where the strategy might depend heavily on the fund manager’s decisions, which can at times be difficult to predict. Factor-based funds are also generally more cost-effective than fully active funds, because the process is largely automated and does not require constant buying and selling.
However, factor investing carries its own risks. It is data driven and just because a strategy has worked in the past does not mean it will always work in the future. Markets go through different cycles, and certain factors may perform poorly during specific periods. Furthermore, investors can replicate similar strategies, thus potentially curtailing its impact over time.
For Indian investors who are considering factor investing mutual funds, it’s important to understand your own investment goals, risk tolerance, and time horizon. These funds can be a useful part of a diversified portfolio, especially for investors looking for a more scientific and disciplined approach to investing. But like all other equity-based investing, here too, patience and holding for the long term are keys to benefit there from.
To conclude, Factor Investing, though novel, data driven and cost-effective has its own pitfalls that an Investor must do their own due diligence about or seek professional advise before taking the plunge. As for the original question whether Factor Investing is sustainable – methinks the answer is Yes, albeit after an evolution process that might involve iterations.
(Ashok Kumar is an experienced investor. He can be contacted at ceolotus@hotmail.com)