Is factor investing better than traditional investing?


Factor premiums are risk-adjusted returns that have a strong economic or behavioural rationale. The most common factors are value, momentum, quality, low volatility and size. Factor investing is done by designing a portfolio of stocks using parameters representing a particular factor. For example, one may use high sales to price or high earnings to price among others to buy value stocks. Similarly, each factor is represented by particular parameters. The benefit of factor-based portfolio construction is that one can back-test these rules over a long period of time going back many decades. 

This helps in analyzing the robustness of the factor over various macros and micro cycles. Traditional discretionary fund involves relying on the expertise of the fund manager in picking stocks. For many traditional funds, one has to rely on the past track record of the manager for evaluation. It is often challenging to find enough funds with long track records for this purpose. Factors on the other hand can be easily backtested over a very long period. On the other hand, the benefits of traditional investment methods are that an experienced manager can use various qualitative information in their portfolio construction that cannot be easily used in a factor-based model. Factor-based and traditional discretionary investing are complementary to each other. Any investor should evaluate to have both as part of their allocation.

What makes momentum investing viable?

Momentum factor is categorized as a behavioural factor which is measured using the change in the price of a stock over a period of time. A momentum portfolio selects stocks with higher total returns compared to their peers. The rationale behind momentum is that this upward or downward trend, driven by market sentiment, would continue for some more time and can be used to generate returns. It is one of the most robust factors which has proven successful globally and also in Indian markets. Even though the factor generates very high returns, it is combined with large drawdowns in bearish markets. But the high risk-adjusted returns provide investors with a strategy that should provide great wealth-creation opportunities over a longer period. For investors who may not like the high volatility of the momentum portfolio, it can be combined with other factors such as quality or value to reduce the drawdown effects because of the low correlation between factors.

How important is Factor investing amid high inflation?

Factor investing has a long history of being used in professional fund management over many decades, especially in the US. Academic research and backtesting have shown it to have worked over a century of available data. Even though factors are affected by macro events such as inflation, it is important to note that their risk-adjusted premiums are robust over the medium to longer term. This is why even though macro events might affect the returns in the short term, the viability of factor investing has survived many such market cycles. Also, not all factors are affected by the same macro event, so a multi-factor approach is advisable in case one wants to reduce the cyclicality of an individual factor return.

A brief overview of Factor Investing trends in India and Overseas.

Factor investing is an area of finance where influential academic work has given rise to a new field of investment products. Academically even though a lot of work was happening around factors starting with the CAPM model, it was the seminal paper by Noble Laureate Eugene Fama and Kenneth French in 1993, which crystallized this concept of factors in a robust framework showing that returns can be attributed not just to market exposure, but also to the value and size premium. This started the exponential work in factors and now we have over 300 documented parameters across various factors.

On the investment side, this gave rise to several investment products. Hedge funds have applied this to construct long-short strategies, while mutual funds and smart beta ETFs have adopted factors as a long-only product. Globally factor-based products have been successfully implemented for many decades. Over time rule based quant models have slowly started taking over the market share of traditional discretionary managers and this share has kept on increasing. In alternative products, a significant percentage of top hedge funds use quantitative methods to manage hundreds of billions of dollars in assets. The asset of these quant-based strategies comes from various sources of institutional and retail clients. It is an institutional way of running money for long-term wealth creation.

We are at the start of a similar journey in India where over the past many years we have seen the rise of quantitative factor-based funds and smart beta ETFs. Factor-based investing is becoming well-known among investors and advisors. The assets in these factor-based funds have steadily risen as investors can see the same wealth-creation potential in these products. As familiarity increases with the high risk-adjusted return capabilities of factor investing and investors recognize the consistency of the strategy across various market cycles, they will eventually become a significant part of core allocation for many investors.

How the consistency of Factors relates to the World of Investing?

Each of the factor premiums exists because of robust economic or behavioral rationale. This premium has been shown to persist over the medium to long term across multiple geographies. But each individual factor behaves differently in various market cycles which makes a single factor cyclical in nature over the short term. The persistence of risk-adjusted return from factor investing has been proven to work across a long period not only through academic research and backtesting through historical data, but also through the robust live performance of factor-based funds globally and in India. Consistent and patient investment in factor based strategies has shown to be a great way of long term wealth creation. The rule based approach has the added advantage of providing transparency in the stock selection process and explanation for the return attribution of a portfolio which has been one of the biggest reasons for its success at both institutional and retail levels globally and increasing domestically as well.

How multi- factor strategy can help in your portfolio construction?

Single factors as explained above, have high risk-adjusted returns along with higher volatility and cyclicality in their returns due to various macro business cycles. But the various factors also have a low correlation to each other given the diversity in the rationale for the persistence of their premiums. This low correlation provides the benefits of diversification when two or more factors are combined to achieve a much smoother risk-adjusted return, say for example by combining quality, value, low volatility and momentum. Factor strategy returns have shown to perform better than the market benchmark over the medium to longer term and should be an important wealth creation allocation for any investor.

Author: Mr. Bijon Pani is the Chief Investment Officer of NJ Asset Management Private Limited and the views expressed above are his own.

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