For a new investor, mutual funds are an ideal form of investment where the investors do not have to worry about selecting the stocks or assets to maximize their wealth but simply choose a better performing mutual fund and invest in the same. However, this comes at a cost in the form of the expense ratio of the fund and other associated costs. But what if it was simple to pick the target investments according to the risk-return parameter of the investor that can lead to maximizing their wealth. This is when the concept of factor investing comes in to picture.
Given below is the meaning of factor investing and a few related details of the same.
What is factor investing?
The concept of factor investing is an investment strategy that is used to select assets based on targetted attributes and factors. It can be referred to as the combination of active investment and passive investment.
In an active investment strategy, the fund managers select the stocks or other assets in a mutual fund based on its objective and the target audience. The ability of the fund manager to select the target investments in curating the fund helps it to perform better than the market as a whole and its peer funds.
Passive investing, on the other hand, does not require the fund managers to actively select the stocks or assets rather they are based on the benchmark usually in the same weightage, and simply track its performance to generate returns.
Factor investing is the investment strategy that combines the best of these two types of investing to ensure that the ultimate goal of generating maximum investor wealth is met. It uses the key parameters that are necessary to form a portfolio and convert it to an algorithm or a technique to select the funds that meet these parameters and avoid others that do not.
The key objectives of factor investing can be highlighted below.
- Forming a structure based on set rules to create a portfolio and ensure that it can outperform the market.
- Ensuring the cost of the investment does not cut the overall potential returns
- Ensuring that the structure can meet the essential requirement of diversification and risk management.
What are the fundamentals of factor investing?
According to the concept of factor investing, the factors that can mainly be associated with the ability of an asset to generate returns can be classified under two main categories namely the macroeconomic factors and the style factors. Let us discuss them in detail hereunder.
Macroeconomic factors
The macroeconomic factors are the broad factors that have an impact on the performance of an asset. Some of such macroeconomic factors are,
- Economic growth
Economic growth talks about the increase in the purchasing power of the consumers which also translates into the increased demand for the product. The stock prices of such products, therefore, increases backed by the strong demand and fundamentals of the company. On the other hand, in a decreasing or falling economy, the demand for some products decreases as well as the purchasing power of the consumers. This makes it difficult for the companies to generate adequate profits and leads to a decline in stock prices.
- Inflation
Inflation also impacts the purchasing power of individuals and their ability to spend on things. The rising inflation will push the cost of goods on the higher side at the same time curtailing the purchasing power of the consumers if the income growth is not able to beat the inflation. This will also impact the business adversely ultimately affecting the stock prices.
- Changes in interest rates
The increase in the overall interest rates in the economy will damage the ability of the individuals and the business to take financial assistance as they may not be able to afford it or repay in full. This again will impact the purchasing power of the individuals and the ability of the business to generate more gains.
- Credit risk
The risk that is taken by investors by investing their funds with companies rather than in government securities (which are risk-free investment options) is the credit risk. The investors are compensated with higher returns for this risk. However, these companies and their bonds have varying degrees of default risks. Hence, investors have to carefully assess this risk before parking their funds.
Style factors
The intrinsic factors of a stock or the micro factors that directly impact the performance of stock are considered to be the style factors. The details of the same are discussed below.
- Size of the company
The size of the company and its market capitalization is used to determine whether it can be classified as small-cap, mid-cap or large-cap company. Factor investing usually focuses on small-cap companies where the growth potential and the earning potential is maximum as compared to large-cap companies.
- The value-based approach of investing
The value-based approach of investing stresses the fundamental analysis of the stocks. It helps the investors select stocks that are undervalued in terms of price-earnings ratio, price to book ratio, dividends yield ratio, free cash flows, etc.
- Momentum
This factor focuses on the momentum of stocks and stocks that have strong and positive results. The idea is that such stocks will continue to provide the upward trend of the prices in the future as well. Factor investing strategy also focuses on short-term returns from the investments which are in the range of 3 months to a year usually.
- Quality of the company
One of the crucial fundamental analysis points is the quality of the stocks and the company. It focuses on healthy companies that have a low debt-equity ratio, higher return on equity, good quality of management, etc.
- The volatility of the stocks
Factor investing also focuses on the stocks that have low fluctuations as these stocks tend to outperform the stocks that have high volatility.
Conclusion
Factor investing helps the investors choose diversified investment options based on specific factors and strategies. It is a good investment strategy to earn long-term gains at the same time reducing the risk of investment. Factor investing helps the investors learn the basics of investing and curate their portfolio to earn better results.
FAQs
The key advantages of factor investing are,
-Risk management
-Diversification
-Balanced strategy to choose stocks for the portfolio
Some of the disadvantages of factor investing are,
-Focus on small-cap stocks that can increase the risk exposure
-No guaranteed returns, cyclical returns as all the factors cannot function all the time.
-Risk of poorly structured strategies that can lead to unnecessary risks for the investors.
Some of the prominent factor funds in India are DSP Equal Nifty 50 Fund, and Sundaram Smart Nifty 100 Equal Weight Fund.
No. Factor investing cannot be considered to be a replacement for active and passive investing but rather an alternate approach that is quantifiable and more refined.
