What is Factor Investing?

By Ravi Samalad |  29-03-22 | 
 

In a recent webinar with Morningstar, Prashant Joshi, Co-Founder & Partner, Fintrust Advisors LLP, spoke about what factor investing is all about and how investors can benefit from it.    

Take us through what factor investing is all about?

Factor is any characteristic that can explain the risk and return of a group of securities. Broadly, there are two factors: Style and Macro. Style is value, quality, and so on. Macro factors are the factors targeting broader macroeconomic pictures, which do not have a direct correlation with an asset class like interest or inflation but do impact the asset prices.

Take us through some of the most prominent factors that are being deployed by fund managers around the globe?

Factors have gained a lot of prominence and in terms of the vastness that they have. Globally, there are five prominent factors that are: Quality, value, low volatility, alpha, and high beta.

Quality looks at attributes like Debt-to-Equity, Earnings Per Share (EPS), Return on Equity and so on. Value takes into account attributes like Price-to-Book, Price-to-Equity, Dividend Yield, to name a few. Low volatility uses Standard Deviation. Alpha is Jensen's alpha or outperformance. Similarly, high beta talks about factor like the market sensitivity of stocks or asset prices towards the environment. Some funds use a combination of any of these factors mentioned above.

A new lens for analysing funds

How are factor-based funds different from Quant Funds?

Factor investing is an extension of quant-based investing. Just like any quantitative model, it takes a team of investment professionals to devise a strategy to make a decision to implement factor strategies. It requires advanced statistical analysis, understanding the impact of factors on securities, doing the asset pricing, having the optimization in place, and so on. Factor investing is a subset of quant-based investing because there's a lot of quant analytics that goes behind constructing a model of a factor.

Since there are more than 300 factors available today, is there any ideal number of factors that are used to identify funds and stocks?

It is advisable to have two to three factors. Factor investing has to be looked in combination with active and passive. It cannot be a strategy in isolation in itself. So, if you have active and a passive strategy, two to three factors, after understanding your current portfolio or investment attributes, would suffice to take care of the portfolio and veer towards the desired objective.

What are the advantages of using factor-based approach vis-à-vis a plain vanilla Index Fund when it comes to passive strategies?   

The issues inherent in active and passively managed strategies have led to the rise of factor investing. Actively managed strategies are conviction-driven allocations where fund manager biases come into play. Moreover, they charge a higher fee than passives and their quest is to deliver returns that are better than the benchmark.

However, as seen globally and off late in India, especially in the Large Cap space, a lot of these active managers despite having fees higher than the passives, are not able to beat the benchmark.  So, that is where investors have got disheartened.

Passively managed strategies benefit from a low-cost advantage and have a transparent way of investing, but returns will be lower to the tune of tracking error and you would not be able to beat the market at any given point in time. So, you are into a dilemma that on an ongoing basis or as the markets are growing and maturing, active managers are not able to beat the benchmarks.

So, that is where factor investment comes into the picture. It combines the benefit of active and passive but tries to generate a higher return than a plain vanilla Index Fund or Exchange Traded Fund (ETF).

How often do we have to revisit the factors or models given the fact we are living in a dynamic world? Can a model be run without tweaking?

Theoretically, it is possible to run a model without tweaking it. However, as time passes and many events unfold, markets, participants change, market attribute changes, be it domestic, globally, from where we were back in the 2000s early and where we are today, a lot of political, economic, geopolitical events will evolve. So, it is prudent to revisit and revaluate the model so that it remains relevant in today's market context.

Low volatility factor is dependent upon a standard deviation. Alpha is Jensen's alpha. So, they are a one-parameter factor. So, a one-parameter factor can be run for a longer time without tweaking it.

Suppose you combine quality and value. In value, you will have three parameters that make quality: Price to Earnings Per Share (P/E), Price to Book Value (PB), and Dividend Yield. Quality will have a Debt to Equity, Earnings Per Share (EPS), or Interest Coverage Ratio. So where a factor has three or more parameters, the time to revisit the factor and validate the thesis of the factor is required to understand it's working fine.

What are the downsides of factor investing?

I think correct factor strategies need to be very rightly thought out. You have to understand that they are strategically implemented basis the overall portfolio and strategy. Factors will behave differently in different market situations. What works in one cycle for one factor might not work in the other cycle for the same factor. There will be an extended period of time where the factors might not even work or might be giving you lesser than the plain vanilla benchmarking.

So, you'll need to have patience. Having said that, with so many factor indices being launched, it is better to have a factor investment that is very well constructed. It should have empirical evidence, a proven track record across market cycles, rather than factors that are looking good namesake but might not be very well constructed.

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