Indian stock markets have outperformed all the major global equity markets, demonstrating a strong and resilient performance. Given the resilience in the markets, investors should take advantage of it. At the same time, diversification can reduce the risk of investment value falling. One way to reduce the investors’ risk is ‘factor’ investing. Globally a well-recognized investment model since the 1990’s, it is gaining ground in the Indian investment spectrum, albeit slowly and steadily.

Factor investing is a technique of defining a set of factors and rules for selection and allocation of stocks in a portfolio, and then creating a rigorous, process-based system to implement these rules. The system eliminates manager biases in portfolio construction. Basically, factors are characteristics of stocks that explain their performance. Some examples of factors are high quality, undervalued, growth oriented, mid/small caps etc.

Factor investing, which has grown in popularity over the past two decades, can offer compelling opportunities for long-term investors. Let’s look at the journey of factor investing. In the 1960s, market beta – defined as the broader market index returns was considered the only factor under the CAPM (capital asset pricing model). Thereafter, factor-based investing kept on growing with more advanced theories like Arbitrage Pricing Theory (1970s), Fama-French Theory (1980s), Single Factor Investing (2000s) and Multi-Factor Investing (now). Multi-Factor Investing seeks to combine two or more factors that aim to deliver better risk-adjusted returns more consistently over time.

Let’s understand some primary factor-based strategies and how to build a ‘system driven’ factor portfolio:

• Value Factor: The value factor strategy involves investing in assets that are considered undervalued relative to their intrinsic worth. This is often done by comparing metrics such as price-to-earnings (P/E) ratios, price-to-book (P/B) ratios, or price-to-sales (P/S) ratios. Stocks with lower valuation multiples are typically considered value stocks. Cheaper stocks are expected to outperform their expensive peers over the long term.
• Size Factor: The size factor strategy involves investing in smaller companies, typically measured by market capitalization. Small-cap stocks are expected to outperform their larger peers over the long term. This strategy aims to capture the size premium associated with smaller stocks.
• Quality Factor: The quality factor strategy targets companies with strong fundamentals, such as high return on equity (ROE), low debt levels, and stable earnings growth. High-quality stocks are often characterized by their ability to weather economic downturns and maintain profitability and are expected to outperform.
• Momentum Factor: Momentum factor investing focuses on investing in assets that have exhibited strong recent price performance. Stocks or other assets that have shown positive momentum in the past tend to continue to do so in the short term, making them attractive to momentum investors.
• Low Volatility Factor: The low volatility factor strategy aims to invest in assets with lower price fluctuations, resulting in a less risky portfolio. Low-volatility stocks can provide more stability during market downturns and can potentially outperform over the long run.

The choice of which factor portfolio to invest in, can depend on various market cycles and economic conditions. Different factors tend to perform better during specific market cycles and economic environments. Here’s a general guideline on which factors are typically favoured during different market cycles:

 

Bull Markets and Economic Expansion:

• Momentum: During strong bull markets and periods of economic expansion, momentum factors tend to perform well. Stocks that have shown recent price strength often continue to do so in these conditions.

 

Bear Markets and Economic Contractions:

• Low Volatility: In bear markets or economic downturns, low-volatility factor portfolios can be appealing. These portfolios include assets that are less prone to large price swings and can provide stability in turbulent times.
• Quality: Quality factor is generally associated with performing well in bear markets due to its focus on financially sound and stable companies

 

Early Recovery:

• Value Factor: During the early stages of an economic recovery, value factor may shine. As markets rebound, undervalued companies generally tend to outperform their peers.

 

Mid-Expansion:

• Size Factor: The size factor, investing in small-cap stocks, can be favoured in the mid-expansion phase. Smaller companies tend to benefit as the economy gains momentum.

 

It’s important to note that these guidelines are general and may not hold true in all market cycles. Factors can interact in complex ways, and the performance of factor portfolios can also be influenced by factors like interest rates, fiscal and monetary policies, and geopolitical events.

Investors should consider their long-term financial goals, risk tolerance, and the specific economic and market conditions when deciding which factor portfolios to invest in. Diversifying across various factors can help spread risk and may be more suitable for long-term investors who want to capture factor premiums without trying to time the market.

Factor investing is a more objective and evidence-based approach to investing. The past performance is thoroughly analyzed concerning the selected factors. This way, an investor can look forward to improving portfolio outcomes, reducing volatility, and enhancing diversification, which is essential for long-term wealth creation.