2.6.1 Factor Investing

What a factor actually is

A factor is a measurable, persistent characteristic of a stock, such as trading cheaply relative to fundamentals, or having shown strong recent price momentum, that has historically been associated with different average returns compared to stocks lacking that characteristic. Factor investing deliberately tilts a portfolio toward stocks exhibiting one or more of these characteristics, rather than simply holding the market as a whole.

A factor is a broad, persistent characteristic that explains a portion of the return difference between securities. Academic research, starting with the Fama-French three-factor model and expanded over decades, has identified several factors that have historically delivered a premium over the market return across multiple countries and time periods. The most widely accepted are Value (cheap stocks tend to outperform expensive ones), Size (small companies tend to outperform large ones), Momentum (recent winners tend to keep winning), Quality (profitable, low-debt companies tend to outperform), and Low Volatility (less volatile stocks tend to deliver better risk-adjusted returns).

Factor investing sits between pure passive indexing and pure active management. A factor index follows rules (like a passive index) but those rules are designed to capture a specific premium (like an active strategy). The index selects and weights stocks based on factor criteria rather than market capitalisation. In India, the NSE has launched several factor indices: Nifty Alpha Low Volatility 30, Nifty Quality Low Volatility 30, Nifty200 Momentum 30, Nifty Midcap150 Quality 50, and others. Mutual funds and ETFs tracking these indices are available and growing in popularity.

How factor funds are typically built

Many factor funds and smart beta indices use rules-based, systematic methods to select and weight stocks according to one or more chosen factors, aiming to capture the historical factor premium at a lower cost than a fully discretionary, actively managed fund attempting the same goal.

Factor fund construction varies. Some funds use a single-factor approach (pure momentum, pure value), while others combine multiple factors in one portfolio (multi-factor). Single-factor funds have more concentrated exposure and will track the factor's performance more closely, including its drawdown periods. Multi-factor funds diversify across factors, smoothing returns but diluting the premium from any single factor. The choice between single and multi-factor depends on the investor's conviction in a specific factor and their tolerance for tracking error relative to the broad market.

Why factors are not a guaranteed edge

Individual factors can, and regularly do, underperform the broader market for extended stretches, sometimes lasting several years, before eventually reasserting their long-run historical advantage. Factor investing requires the same kind of patience through difficult periods that any long-term strategy demands, and it is not a way to reliably avoid volatility or underperformance in any given short period.