A Look at Factor-Based Investing Strategy

While relatively new in India, factor investing is akin to a middle path, which combines features of traditional active and passive investing. As the name suggests, it is an investment strategy that uses various factors to select stocks. 

Generally, the factors used to select stocks are in two types of categories: macroeconomic and style.

Some of the various common macroeconomic factors that are considered include gross domestic product (GDP), inflation, credit, interest rate, and liquidity.

Similarly, the most common viable investment style factors are value, momentum, quality, low volatility and size. Factor investing involves generating a portfolio of stocks while taking into account parameters that represent a particular factor. For instance, the value factor involves looking at stocks with low market prices as compared with fundamentals such as their sales, earnings, or cash flow on a per-share basis.

The momentum factor involves tracking stocks with high returns relative to the market in the past six to 12 months.

The quality factor tracks companies with healthy balance sheets and consistent growth and profitability.

Similarly, the low volatility focuses on identifying stocks with low realised volatility in price returns.

There are various long-term approaches to factor investing, that an investor can choose to adopt. For example, an investor can choose multifactor strategies, which combine momentum, quality, size and value by maximising exposure to stocks with multiple other factors, in combination. This strategy ensures better portfolio diversification and the least reliance on any particular factor in order to seek high returns.

Then, an investor can look at a well-diversified portfolio of single-factor strategies wherein a part of an investment portfolio could be allocated to momentum, dividend growers, and another quality. Multiple financial goals can be achieved this way, which could be improving returns, gaining regular income, or minimising risk.

Finally, an investor can eye a combination of the above-mentioned two approaches, which could provide the highest degree of choice, while offering the benefits of diversification as well as flexibility.

Factor investing is known to improve the risk-adjusted performance of a portfolio in the long run.