Factor investing is the new buzz word in the Indian equity investing landscape. It is often referred to using different terms – from the subdued, ‘rules-based’ investing, to the more exciting ‘Quant’ investing. But what exactly is this new style of investing all about, and why should investors care?
Factors through the eyes of ‘Bollywood’
Every year, hundreds of movies release in Bollywood, but not all of them end up making money. While some go on to become block buster hits, others bite the dust. What could determine the success of a Bollywood movie? The following factors might lead us closer to the answer:
- Gripping storyline
- Star-studded cast
- Special effects and high flying action sequence
- Catchy sound track
- Lack of competition
Just like how the above characteristics help explain the commercial performance of the movie, the characteristics of stocks that help explain their performance are called ‘Factors’. The adjectives we use to describe stocks, like ‘growth’ stocks, ‘under-valued’ stocks, are all factors.
In our Bollywood example, we used a rough subset to identify a few relevant factors of success. But the factors in the investment world have been identified following rigorous scientific research and statistical testing of over 100+ years of historical data. The most widely accepted factors are:
Characteristics of Factors
The primary requirement for any parameter to be called a factor is that it should be able to enhance returns over the benchmark over a period of time; but that alone is not sufficient. Researcher and author Larry Swedroe came up with a checklist of additional criteria to be met before any parameter can be called a factor:
- Persistent: Thereturn enhancing properties of the parameter must hold true over extended periods of time, spanning various market and economic cycles.
- Pervasive: The parameter must demonstrate consistent results across various geographies.
- Robust: The parameter must not be susceptible to small changes in definition of fundamental descriptor used to express the factor.
- Investable: The parameter must continue to demonstrate outperformance even after transaction and market impact costs have been considered.
- Intuitive: There must be a logical explanation for why the parameter has been able to exhibit the observed outperformance.
Integrating Factors in investment portfolios
The use of quantitative techniques is not a new phenomenon in investing; in fact, it might actually be as old as investing itself. When Ben Graham popularized his ‘cigar-butt’ approach of buying companies trading at deep discounts to their book value, he was trying to take exposure to the value factor. Similarly, through his philosophy of buying ‘high-moat’ companies trading at reasonable prices, Warren Buffett was actually trying to identify companies that had high quality and value factor exposures. But these approaches typically used factors only as a corroborator of investment thesis. Portfolio construction was largely governed by the manager’s discretion.
It was only after factors such as value and momentum were formally defined in the 1990s that market participants incorporating these factors into portfolios in a strictly rules-based manner. This purely rules-based and unambiguous approach of identifying and selecting companies with high exposure to a target factor is known more popularly today as ‘Factor Investing’. It is a three step process:
- Using a quantitative descriptor to express a factor. For e.g., Price to Book (P/B)
- Defining rules to include or exclude companies by using these descriptors to create a portfolio. For e.g., a value portfolio could be formed by selecting the 30 percentile companies with the lowest P/B ratio.
- Applying these rules on an investment universe at a pre-defined periodicity (annually, quarterly, etc.)
Factor Investing strategies have found widespread adoption among institutions, HNIs, as well as retail investors in the developed world. ~USD 1.9 trillion was managed using factor strategies globally in 2017, rising from ~USD 650 billion in 2011, growing at ~20% annually. Blackrock further estimates these strategies to reach ~USD 3.4 trillion by 2022. However, in India, awareness of factor investing strategies has been limited thus far, and factor-based funds are just starting to come up. As investors look for different ways to enhance their returns, these strategies might offer an interesting alternative. However, allocation to these strategies must be done only after understanding the risks inherent in them.
Disclaimer: This article has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The stocks/sectors mentioned herein is for explaining the concept and shall not be construed as an investment advice to any party. The information / data herein alone is not sufficient and shouldn’t be used for the development or implementation of any investment strategy. It should not be construed as an investment advice to any party. All opinions, figures, estimates and data included in this article are as on date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article. Investments in securities markets are subject to market risks, read all the relevant documents carefully.