Factor investing: Unlocking market secrets with value, momentum, and quality

At its core, factor investing targets specific characteristics, or “factors,” in stocks that have been shown to deliver returns above what most diversified portfolios achieve. While rooted in rigorous academic research, it’s not just about chasing trends. Ajay, who’s been riding the momentum factor for the past two years and happily counting his gains, might disagree. But there’s a method to the madness.

Read this | Indian investors are discovering the power of factor investing

Though it feels new, factor investing has been around for a long time. What’s changed is the rise of financial products, like factor-based indices and mutual funds, that explicitly follow specific factors. 

Historically, fund managers would optimize for different factors at various points in the market cycle. Today, with increasing emphasis on discipline and style commitment, investors are demanding products that stick to a particular style — allowing them to better manage exposure across cycles.

In India, certain factors are more popular, and we’ll take a look at a few.

Value investing is probably the most well-known, advocated by legends like Warren Buffett and Benjamin Graham. Imagine your frugal uncle who always finds the best deals, whether groceries or vacations. That’s value investing — buying stocks for less than their intrinsic worth. Value investors focus on metrics like price-to-earnings and price-to-book ratios.

Value stocks offer two main benefits: First, they tend to rise as their price reflects their true worth. Second, they provide a margin of safety during downturns since they’re typically undervalued.

However, value investing isn’t always in vogue. During growth sector hype, value stocks might seem like yesterday’s news. But when the euphoria fades, value stocks often stand strong.

Next, I’ve nicknamed the momentum factor the ‘hot wheels’ factor. Momentum investing is all about riding the wave of rising stocks — its mantra: “buy high, sell higher.” As the name suggests, momentum involves buying stocks with strong price trends in the hope they’ll continue to rise. It’s a thrilling approach that’s benefited many in India, especially in recent years when trends have been largely upward.

But like a gambler on a lucky streak, momentum can turn on you. When markets reverse, those riding momentum might find themselves saying, “Easy come, easy go.”

The quality factor is a favourite among seasoned investors who take a long-term view. These are companies with strong fundamentals — steady earnings, low debt, and solid balance sheets. Think of them as the reliable chartered accountant who grows wealth slowly but surely, without drama. These companies, often found among India’s top 100 by market capitalization, offer stability rather than excitement.

Quality stocks tend to shine during market downturns, providing a safe harbor when other investments falter.

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Sometimes, it’s smarter to dip your feet in the pool while sipping your favorite drink. The low volatility factor is for investors who want to minimize risk while generating returns slightly above fixed income. Picture your neighbor who’s content with a comfortable life, making just enough smart investments to stay ahead of inflation. These stocks reduce volatility, offering a smoother ride in turbulent markets.

While low-volatility stocks won’t outperform in a bull market, they offer peace of mind during declines.

So, is factor investing your cup of chai? Absolutely. In fact, it’s for every investor. 

Factors are the foundation of any portfolio, and the beauty of this strategy is you don’t have to stick to just one. You can mix multiple factors depending on your goals and risk tolerance.

Also read | The perennial debate in factor investing: Quality versus value

Think of it as an expressive painting—different hues and shades coming together to create a masterpiece. By combining value, momentum, and quality, you can optimize your portfolio across cycles for superior risk-adjusted returns. There are also multi-factor indices and mutual funds that do the heavy lifting, providing a simpler option for investors who prefer not to manage their own allocations.

Nirav Karkera is head of research at Fisdom, a wealthtech startup.