Factor Investing is the new kid on the block

What exactly is Factor Investing?

If you are an investor in mutual funds, you would have come across the term “Factor Investing” often in recent times. Of late there have been a number of new fund offerings (NFOs) by mutual funds, which are factor funds. The NSE has certain factor indices and these factor funds are passive (or semi-passive funds) indexed to such factor indices. How is a factor index different from a generic index like Nifty or Bank Nifty? A factor index focuses on a theme that can outperform a plain vanilla index fund.

Factor Funds fall somewhere between active funds and passive funds. An active large cap fund has a fund manager who is constantly taking calls on what stocks to buy, what to sell, what to add and what to exit. There is discretion involved in active funds. On the other hand, a passive fund pegs its portfolio to an index like the Nifty or the Bank Nifty and ensure to minimize tracking error. Factor funds are partially passive, in the sense that they are pegged to an index. However, factor funds are also partially active as such indices are theme based and require regular churn, resulting in churn of the factor fund portfolio too.

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Some home truths about Factor Investing

Here are some basic home truths investors must understand about factor investing. 

1. What do we understand by a factor? A factor helps to explain or identify the unique features or characteristics that drives the returns on a stock. For example, a fund may be outperforming the index because it is in the right place at the right time. Like, if you are in a momentum stock in bull markets and dividend yield stock in bear markets; your portfolio is likely to do better. Factor investing actually isolates such factors.
   
    
2. Factors make a particular investment better or worse. But why do factor really matter. Let us say, the fund you are invested earned 18% last year against 13% for the index. You may believe that the 5% additional returns were generated by stock selection. Actually, it may have come by chance because the fund happened to be in the right factor or theme at the right time. Factor investing actually isolates factor impact.
   
    
3. How does factor investment help the investor. Remember, that in terms of cost; factor funds cost more than passive funds, but less than active funds. When investors pick a fund with clearly identified factors, it helps the investor to earn higher risk-adjusted returns compared to a pure and passive index portfolio. In short, factor funds also generate alpha, but it is not from stock selection but from factor selection.
   
    
4. Factor investing brings about a clear demarcation of the source of returns. In the past, you just classified returns into market returns (Beta) and excess returns (alpha). Now the alpha returns are further classified into factor returns (generated by factors) and excess returns (generated by fund manager selection). It helps identify what the fund manager is actually generating through stock selection.
   
    
5. To sum it up, the factor funds capture full Beta and part Alpha. The typical passive index fund only captures the beta part of the returns or the market returns. The factor fund captures market returns plus that portion of alpha that is generated by factors and thus enhances returns, by taking on slightly additional risk. These additional returns are generated on the back of a small additional cost by way of total expense ratio (TER).

A classic of a factor fund is the recently opened NFO of the Bandhan Nifty Alpha 50 Index Fund. This fund is benchmarked on the factor index (Nifty Alpha 50 Index). But, first a little more on factor funds.

Types of factors available in India today

Most of the factors are rule-based and based on these rules an index is created and the factor fund is indexed to that factor index. A quick look at some popular factors.

• A very popular factor is the Momentum Factor. This is based on stocks were momentum is currently favourable. They do well in bull markets but underperform in bear markets.
  
   
• The second factor is Low Volatility Factor. Here, the focus on stocks with volatility (standard deviation of returns) less than average. These volatility factor funds do well in range bound markets or even in bear markets. 
  
   
• The third is Earnings quality factor. Here quality companies are identified based on factors like low debt, stable earnings, above average ROE etc. These factor funds can outperform in stable and long term bullish markets.
  
   
• The fourth is the value factor, where stocks are selected based on valuation attractiveness i.e., lower than average P/E or P/BV or higher than average dividend yield. These perform better in long term range bound markets. 

These are just examples and in practice, there can be many more such factors that can be identified and invested in based on an appropriate index. 

Factor Investing case study: Nifty Alpha 50 Index

One of the popular factor indices on the NSE is the Nifty Alpha 50 index. Here is how this factor index has performed in terms of past returns.

• Nifty Alpha 50 index generated 3 year rolling returns of 17.4% annualized as compared to an average Nifty 50 return of 13%. However, this also means  higher volatility since the Nifty Alpha 50 index has average volatility of 24.6% compare to the average Nifty volatility of around 14%. It is a high risk and high return game and works best in the long run.
  
   
• The alpha (excess returns) generated by the Nifty Alpha 50 index is much more in bull markets than in bear markets or flat markets. For instance, in the bull market of 2005-2007, the Nifty Alpha 50 index generated excess returns of 146%. However, in the period post the IL&FS crisis, it underperformed the Nifty. 
  
   
• The sector exposure keeps changing this factor index. Between, September 2022 and September 2023, large cap exposure fell from 40% to 16.5%, while small cap exposure surged from 12% to 33%. Over the last 2 years, sector shift has been from IT dominated to BFSI dominated. 

These factors have, over a longer time frame, done better than normal generic indices. However, they also entail higher levels of risk and costs. The answer lies in taking a longer term approach to factor investing of 5-7 years for best outcom