Factor Investing: How to Build Smarter Portfolios with Low-Cost Funds

The mutual fund industry in India has grown rapidly over the past 10 years, becoming one of the fastest-growing markets in the world. This growth is fueled by more people learning about investing, better digital access, and the increasing popularity of systematic investment plans (SIPs).

In the last decade, Index Funds and ETFs have gained popularity in India. In 2014, they only made up 2% of the total assets under management (AUM). By June 2024, they accounted for more than 17% of total AUM, which has surpassed ₹10,00,000 crores. This growth has led Asset Management Companies (AMCs) to introduce new strategies to meet investors’ needs. One of these strategies is factor investing, which offers a smart way to improve returns, manage risk, and diversify portfolios.

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What is Factor Investing?

Factor investing focuses on certain characteristics of securities that can help generate returns. These characteristics or “factors” are available in low-cost Index Funds and ETFs in India. Factors include attributes like quality, value, size, momentum, and low volatility. By focusing on these, investors can customize their portfolios to better meet their goals. For example, Value Investing targets undervalued stocks to profit from market inefficiencies, while Momentum Investing looks for stocks with rising prices, betting that these trends will continue.

Benefits of Factor Investing:

1. Wealth Creation: Factor investing captures specific factors that have historically outperformed the market. It works across different markets and asset classes, and helps build portfolios that can adapt to changing economic conditions. If done right, factor investing can offer long-term wealth creation.
2. Risk Management: Factor investing helps reduce risk by selecting factors that perform well under different market conditions. For example, low-volatility stocks can help cushion against losses during market downturns.
3. Transparency: Like Index Funds and ETFs, factor investing is often rule-based, meaning it follows clear guidelines for choosing investments. This makes it easy for investors to understand how their portfolios are managed.
4. Diversification: Factor investing improves diversification by spreading investments across factors that don’t move together. This means if one factor underperforms, the impact on the overall portfolio is reduced. Many investors mix different factors to achieve better risk-adjusted returns.
5. Accessibility: Thanks to technology, factor investing is now more accessible. Investors can easily implement factor-based strategies using online tools and platforms, making it a cost-effective investment solution.

Things to Consider Before Adopting Factor Investing:

1. Periods of Underperformance: Certain factors may underperform in specific market conditions. For example, value stocks may not do well when growth stocks are thriving. Over-relying on one factor could lead to big losses if that factor underperforms.
2. Sophisticated Analysis Needed: Identifying the right factors requires advanced data analysis and models. Errors in this process can lead to underperformance.
3. Market Changes: Shifts in market conditions or investor behavior can reduce the effectiveness of certain factors. For instance, if too many investors start using the same factor strategy, its advantage may disappear.

Understanding these risks is essential for investors who want to use factor investing. Diversifying across several factors and keeping an eye on the market can help reduce these risks.

Investor Profile

Factor investing allows investors to tailor their portfolios according to their financial goals and risk tolerance. For example, an investor who can handle more risk might focus on factors like momentum or size, which can be volatile but offer higher returns. Those looking for more stability may prefer quality or low-volatility factors. Globally, sophisticated investors often blend multiple factors to create their core equity portfolios.

In conclusion, factor investing is a systematic way to capture specific drivers of returns. While it offers potential for higher returns and better risk management, investors should be aware of the risks and align their strategies with their own investment goals. By understanding and carefully selecting the right factors, investors can improve their chances of achieving their financial objectives.

(The author, Vikash Wadekar, is Head of Passives Business, Axis Mutual Fund. Views expressed are personal.)