Demystifying factor-based investing: A new opportunity for investors
Source: Live Mint
Imagine you’re shopping for shoes on Amazon. You start with thousands of options but gradually narrow your search using filters like category, colour, size and material until you find the perfect pair. This process mirrors the concept of factor investing: using specific criteria, or factors, to filter and select investments.
What are factor-based index funds?
Factor-based index funds, also known as smart beta or strategic index funds, are a sophisticated extension of passive investing. These funds invest in stocks that are part of indices created by NSE or BSE but with a twist. Traditional indices like the Nifty 50 or Sensex are built around companies’ market capitalization. Factor-based indices, however, use specific filters—such as momentum or low volatility—to refine the selection process.
In essence, factor-based index funds sit between active and traditional passive funds. They retain the transparency and cost efficiency of passive funds while incorporating some of the precision associated with active management.
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What are the different types of factors?
Broadly, factors can be categorized into technical (price-based factors) and fundamental (balance sheet-based factors). Examples of price-based factors include momentum, low volatility, alpha, and beta. On the other hand, fundamental factors focus on metrics like quality or value derived from a company’s financial statements.
Some indices are based on a single factor, while others combine multiple factors. For example, the Nifty 100 Low Volatility 30 index includes the 30 least volatile companies among the Nifty 100. The Nifty 500 Multicap Momentum Quality 50 (MMQ 50) index combines momentum and quality factors to select its components.
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Why should you consider factor-based investing?
The appeal of factor-based investing lies in its potential to deliver higher returns over the long term. Rolling return analysis provides a reliable way to evaluate this. We examined 25 of the 44 different factor indices available on NSE across investment horizons of 1 year, 3 years, 5 years, and 10 years, spanning April 2005 to October 2024.
The results were remarkable for a 5-year horizon, which is ideal for equity investments. Of the 25 indices, only one (Nifty High Beta 50) underperformed the Nifty 50 TRI’s (Total Return Index) average return of 12%. All others outperformed, with some delivering significantly higher returns. For instance, the Nifty Midcap 150 Momentum 50 index averaged a return of 22%, outperforming its broader counterpart, the Nifty Midcap 150 TRI, by 7%.
The MMQ 50 index stands out with an average 5-year return of 21%, compared to 12% for the Nifty 500 TRI. impressively, on a 5-year rolling basis, the MMQ 50 outperformed the Nifty 50 TRI 99.5% of the time in the observed 3,596 data points.
Extending the analysis to a 10-year horizon further underscores the potential.
Contrary to the perception that higher returns come with higher risk, factor-based indices often demonstrate lower downside risk. For instance, on a 5-year rolling basis, the Nifty 50 TRI has a downside deviation of 3%, while MMQ 50’s deviation is just 1%, indicating more consistent performance.
Understanding the nuances
While factor investing offers exciting opportunities, it’s essential to understand a few key nuances. Many factor-based indices in India are relatively new, with the first batch launched in 2017. Some indices were created as recently as September 2024. Historical performance data, therefore, relies on back-testing, which may not always predict future outcomes perfectly.
Additionally, factor indices can experience more frequent changes in their composition compared to traditional large-cap indices. This periodic reshuffling might lead to tracking differences in passive fund management.
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The takeaway
With almost 20 years of rich historical data and the compelling outperformance of factor indices over traditional benchmarks, this is a space that investors cannot afford to ignore. The combination of higher returns, lower downside risk, and innovative strategies makes factor-based investing a powerful addition to a diversified portfolio.
Saurabh Mittal is founding director of Circle Wealth AdvisorsPvt.Ltd
