Enhance risk-adjusted returns with factor investing

While ‘factor investing’ usually requires a lot of data and numbers, factors are very intuitive to understand. These strategies are typically created as a basket of stocks. However, as quantitative methods are used in making these strategies, the baskets are well diversified and, more often than not, carry a risk less than the Nifty index. It scores higher in terms of performance as well.

While the Nifty 50 Index has given around 10% CAGR since 2010, most factor strategies—based on Nifty thematic indices— have a much higher return. Notable examples will be momentum strategies beating the index with a wide margin and giving 20% CAGR in the same period and even factors like low volatility and value giving a 2-8% higher return in the long term. Since India has been a growth market with significant bull markets, the best performing factor in India has been ‘Momentum’ or ‘Trend Following’. Momentum is followed closely by ‘Growth’ and ‘Quality’ factors. The ‘Low Volatility’ factor gives good performance at extremely low risk, while ‘Value’ outperforms in the long term.

As the name of each factor suggests, the stock selection based on each factor differs. For example, the value factor picks stocks that are inexpensive compared to their fundamental attributes.

We need to remember that no one factor is the single solution. For example, in a bull market like 2021, momentum has given astronomical returns, while quality and value strategies have drastically underperformed in comparison. But as the correction started in the fourth quarter of 2021, momentum has lagged while value and low volatility have done much better.

Thus, a single factor can be part of a satellite portfolio of an investor because it only works in specific market regimes.

That means, depending on the market conditions, allocation to factors has to be shifted. For example, in a trending market like 2021, we must allocate more to momentum, but as the volatility creeps in, we should shift to more quality and value allocation.

However, to use the power of factors, a much more innovative approach is multi-factor investing. When you combine various factors, you get an added advantage from diversification because the factors do not move together. Generally, the factors in the multi-factor approach are chosen such that the correlation between any two factors is less than 50%. Hence, if one factor goes down in a multi-factor portfolio, the other would come in to support. Thus a multi-factor portfolio would give you a decent performance due to the constituent factors and minimize risks.Based on 10 years of analysis using Nifty thematic , multi-factor approach can give a 3-5% lower risk over the index while adding 5-10% outperformance in the long term.

In a bull market, a multi-factor strategy might lag a momentum strategy in terms of returns and in a bear market, low-volatility might outperform the multi-factor strategy. However, this approach would have a much lower risk and better risk-adjusted return, making it ideal to become the core of someone’s portfolio.

Note that these approaches are complex for most retail investors as they require data crunching and periodical rebalancing. To get exposure to multi-factor strategies, investors are better off looking for funds or advisors that follow a multi-factor approach.

Obviously, there are ways of combining factors. Some people choose their preferred factors and give them weightage depending on market conditions.

Though it’s a bit of a challenge, understanding and selecting a fund or portfolio manager who is adept and can dynamically allocate weights to multiple factors based on the market conditions can deliver higher returns than the one who equally allocates to all factors in a static way across all market situations.

The bottom line is that factor investing is not only a fascinating area of research but also a good way to generate a better-than-market return at a conservative risk, mostly. These strategies depend on numbers—be it technical or fundamental—and results will depend on quality of data and construction of your portfolio.

Sonam Srivastava is founder of Wright Research.