Factor-based funds are catching on in India. Are they right for you?

However, a growing number of investors are now shifting to factor-based funds, also known as factor funds or smart beta strategies, which aim to outperform the benchmark. They currently account for 2% of total ETF and index fund investments, with AUM exceeding ₹27,000 crore.

One of the key advantages of factor funds is that they blend the benefits of both active and passive investing. They offer the potential for higher returns like actively managed funds, but at a relatively low cost, like passive funds. Factor funds select for specific factors such as momentum, value, volatility, quality and value. Research has shown that these factors have historically influenced investment returns, forming the basis of most popular factor funds. Let’s decode some prominent types of factor funds.

Momentum factor funds (AUM: ₹15,000 crore+)

Momentum factor funds track momentum indices, which include stocks showing strong upward price trends on the expectation that these trends will continue. Price movement is the core criteria for selecting these stocks. Globally, this is the second largest factor-based strategy.

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While momentum investing holds high return potential, it also carries risks such as increased volatility and susceptibility to market corrections. Momentum indices manage these risks by adjusting for volatility and selecting the top-performing momentum stocks. These indices are rebalanced every six months to adapt to shifts in momentum over time, allowing sectors such as healthcare, pharmaceuticals, infrastructure and energy to lead performance at different times. 

This strategy effectively capitalises on rapid sector shifts. Momentum strategies have consistently outperformed benchmarks and are often seen as superior to other factor strategies due to their adaptability, sector and style agnostic nature. This strategy performs best in bull markets.

Low volatility factor funds (AUM: ₹6,000 crore+)

Low volatility factor investing allows investors to achieve good returns while focusing on low-volatility stocks that have historically outperformed the broader market over the long term. In contrast to momentum investing, which seeks high risk and potentially higher returns, low volatility aims for lower risk.

While it may not yield higher absolute returns than momentum investing, it can provide better risk-adjusted returns, making it a robust strategy during turbulent market conditions. It can also reduce drawdown risk i.e. the potential fall from peak values.

Value factor funds (AUM: ₹2,500 crore+)

Value is one of the oldest and most widely used investment strategies. Stocks are selected based on attractive valuation metrics such as low price-to-earnings, price-to-book and price-to-sales, as well as high dividend yields. The premise of value investing is to build a portfolio of “less expensive” stocks in terms of valuation, a concept popularised by stalwarts such as Benjamin Graham and Warren Buffet. 

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Value factor funds have lower correlation with the broader market, offering investors a good level of diversification. This strategy typically performs well during recovery phases and bull markets.

Quality factor funds (AUM: ₹1,000 crore+)

Quality factor investing targets stocks with strong fundamentals, emphasising operational earnings and balance-sheet strength. These stocks typically have low debt and stable earnings growth, making them particularly effective during bear markets.

Mix & match factors: Some funds combine multiple factors such as alpha, low volatility, dividend yield and momentum to optimise returns.

Choose wisely

Factor-based investing can be a powerful tool for long term wealth creation, appealing to diverse investor preferences while enhancing portfolio diversification. While factor funds have shown potential for long-term gains and often outperform benchmarks, consistency is not guaranteed, as some factors may underperform in certain market conditions. Systematic investment plans (SIPs) could be an effective way of investing in factor funds.

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It’s also important to remember that most factor fund strategies rely on historical data and assume that past performance will continue. However, investors should tread cautiously as market dynamics evolve and past performance does not guarantee future results.

Rasmeet Kohli is a senior assistant general manager at the National Institute of Securities Markets. Views are personal.