How investors can use factors to minimise volatility

By Ravi Samalad |  02-04-22 | 
 

In the previous post, we covered the types of factors and the advantages of using factor as opposed to plain vanilla indexing. In this post, Prashant Joshi, Co-Founder & Partner, Fintrust Advisors LLP, takes us through how different factors perform during various market cycles and how factors can be deployed in your portfolio.     

Should investors go for a fund that is using a single factor or prefer those which are using multiple factors?

There is no straight jacket answer. It depends on the investor and her understanding of various factors. Different factors display strengths and weaknesses in different economic and market environments. One factor outperforms another in one market environment and the other outperforming the latter.

We did a very interesting market analysis. We broke the market into three cycles - upcycle, downcycle, and flat cycle. We found that in a upcycle, single factors tend to respond faster to market dynamics. Similarly, in a downcycle, single factors are highly responsive to the situations. However, the multifactor models do not fall in the same magnitude as the single factor indices.

In a flat cycle, the multifactor indices did better than others. Multifactor indices help you to counter the cyclicality of various single factors. So, if an investor understands factors, their impact, their responsiveness, is aware that they will respond to the situation way faster, and is agile and able to adapt, she should go for a single factor. However, on a longer timeframe, if somebody wants to have a lesser volatility approach to it and needs a bellwether, then a multifactor strategy is more preferred.

What is the best combination of factors? Is there any ideal combination of factors, which investors can use to generate alpha?

If somebody is looking at targeting only low volatility in his/her portfolio, she can go for a low volatility or low standard deviation factor in the portfolio. We have seen a trend among new investors who are coming into factor investing is that they tend to combine multiple factors (low volatility, momentum, value).

Under each of these factors, there is a basket of 15 to 40 stocks. So, if you are in isolation choosing individual factors and combining them you will end up having a portfolio of factor with more than 90 to 100 stocks. This will not help diversification and deliver subpar returns.

In case, you opt for multifactor, then ideally what we have seen globally, anything between two to three factors historically has a better track record across various market cycles and environments. So stick to that and choose a factor which gives you the combination of all three together, because three factors when combined together will eventually have a portfolio of 25 to 30 stocks and not 90 when you choose separately.

Should investors use a combination of passive, smart beta, and actively managed funds? How should factors fit into the portfolio?

Active investing is about actively monitoring the portfolio and gearing it towards the targeted objective basis your portfolio requirement. This is where factor investing comes in handy. For instance, in March 2020 crash, everybody was talking about quality. People were searching for companies that are low on debt and can tide over the pandemic.

People didn’t realise we already had the Nifty Quality 50 factor which has a basket of quality stocks, which could be deployed. In active management, you have to accept the fund manager’s style.

You cannot customise a mutual fund portfolio according to your needs. But on that very given day, you can take a meaningful exposure to a low volatility factor model ETF and reduce the overall volatility of your portfolio. So, both of these decisions are complementing active. So, they can be used in actively managed strategies to target different market conditions.

What is Factor Investing?

We are seeing a lot of volatility in the market due to selling and some global macro concerns. So, right now, what would be the best factors to use?

Volatility has to be viewed in a very different fashion. It has pros and cons. In times of uncertainty, low volatility factor tends to outperform the rest of the markets.

If an investor chooses a single factor say value,  is there a risk of getting into a value trap?

There is no right and wrong view. A value trap occurs when an investor looks at the fundamentals and market prices of a stock and it appears that the stock is valued at a discount. But in the end, it turns out not to be the case, that is the time it becomes a value trap. So, how you overcome a value trap is more important. You avoid a value trap by conducting thorough due diligence by adopting PESTEL analysis, an acronym for political, economic, social, technological, environmental, legal, and macro forces which affect the company. You have to look at your due diligence to avoid this value trap.

So, can a factor or any quant model alone can do this due diligence without human intervention? The answer is no. The chances that you will have a value trap in a quantitative model which lacks the human intelligence of due diligence is higher. Having said that, the factor index that is constructed usually will have 15 to 20 stocks. So, by the way of stock diversification that this risk is mitigated to some extent.

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