Factor Investing: Building a portfolio based on market factors

In life, we adhere to certain rules and limits, but when it comes to our financial lives, we often plunge into investments without a second thought.

This lack of discernment can lead to disappointment, as high return expectations clash with inadequate research.

This article sheds light on a more structured approach – factor investing – and avoid falling into the trap of labelling the stock market as a mere ‘gambler’s place’.

What is Factor Investing?
Factor investing involves attributing the returns of your equity portfolio to specific factors such as value, quality, volatility, and market capitalisation.

These factors act as persistent and well-documented drivers of asset class returns, offering investors insights into expected returns and aiding in seeking outperformance or managing risks effectively.

With the accessibility of exchange traded funds (ETFs), factor investing is no longer confined to the elite, presenting a balanced mix of passive and active investment management.

Understanding Long-term Drivers of Equity ReturnsValue Factor
This factor indicates that stocks with low P/E multiples or high earnings yield tend to offer higher returns, especially during stock market recoveries.

Momentum Factor
Strong price momentum effects have been observed in various asset classes globally, indicating that past winners continue to outperform losers.

Growth Factor
This factor gauges a company’s potential based on historical or projected growth rates, signalling potential strong future stock price performance.

Quality Factor
The quality factor is based on complex accounting information, focusing on companies with little divergence between accrual and cash earnings.

Size Factor
Smaller companies, such as midcaps and smallcaps, are believed to outperform larger peers over the long run due to untapped markets and growth potential.

Application of Factor Investing in Building a Robust Investment Portfolio
Timing factor exposures precisely is challenging, akin to timing the market. A multi-factor approach, rather than exposure to individual factors at different times, helps reduce factor-specific risks without compromising portfolio returns.

Investors can adopt this approach while remaining bullish on a specific factor, adjusting exposure accordingly.

Pros of Factor Investing
• Sits between passive and active approaches, appealing to investors on both sides.

• Enhances returns for passive investors with defined costs and risk attributes.

• Backtesting factors over extended periods provides historical insights.

Cons of Factor Investing
• Factors have specific cycles of outperformance and underperformance, making predictions challenging.

• No single factor works across all market conditions, requiring proactive adjustments.

In summary, factor investing offers a streamlined approach to investing by considering common variables influencing a security’s risk-return dynamics.

Adopting a multi-factor strategy provides resilience against any single factor going out of favour. When used mindfully, factor investing can be a powerful tool for the average investor, striking a balance between passive and active investment approaches.

Note: The article is for information purposes only. This is not an investment advice.

(The author is Vice President of Research, TejiMandi)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)

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