Investment Ideas: Factor Investing: 5 Ways Better Than Traditional Investing

Factor investing is an investment strategy where fund managers select stocks based on certain attributes. These traits are the driving force behind stock returns.

For example, someone picks stocks that are undervalued by investing in value as a factor.

Basically, there are two types of factors: macroeconomic factors and pattern factors. Macroeconomic factors that are not directly related to financial assets affect their prices. For example, GDP growth, interest rate, inflation, etc.

On the other hand, pattern factors are directly related and indicate risks and returns within asset classes. Some of the pattern factors are value, quality, volume, momentum, etc.

In factor investing, your portfolio may be constructed based on one or several factors. For example, momentum funds include those securities that have shown upward price movements in the past 16 months.

Here, momentum is one factor that is used while creating a portfolio. You will find many chests based on one factor such as value, momentum, or quality.

An example of a multifactor investment could be a fund with low value and volatility, in which undervalued stocks that have less price variance over time are included.

Research also indicates that Warren Buffett’s stock-picking patterns can be explained by factors.

Researchers have shown that to double its returns, one can use factors of quality, value, and factors of low volatility.

Why is factor investment better than traditional investment?
Factor investing proves to be a better investment strategy as per the following criteria.

1) performance

The old-fashioned way of building a portfolio of stocks is where fund managers do basic research by examining how a particular company performs compared to its competitors, its management and the reasons why a sector or company is likely to do well in the future.

Factor investing is a rule-based investment strategy that strategically selects stocks that have specific attributes.

For example, a momentum factor fund will rank all the stocks in its world based on the degree of momentum and then rank the stocks and give them weights, these weights can be either equal weights or weights based on their degree of momentum.

Similarly, in a multi-factor model, all stocks are ranked based on multiple factors, and a portfolio is created. Actual value is generated when algorithms can give weights to different factors that are likely to perform well in current market scenarios.

Let’s take a look at factor indicators created by NSE. This analysis is from April 1, 2005 to April 30, 2022

ETMarkets.com
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We can see that all factors have been able to beat the index over the past 17 years. Value as a factor hasn’t been very good over the past 17 years, but over the past year or so, it has done well.

Also, if we look at volatility, which is a measure of risk, all factors except value have a lower risk than Nifty50.

In fact, the low volatility factor has the least volatility, and even with such a low risk, it managed to beat the indicator.

2) Better transparency
Factor investing provides you with more transparency than traditional investing. In traditional investing, the reason for poor returns or poor performance can be a mystery to you. However, when you invest in a factor-based fund, you can easily understand why the fund is performing.

3) Low cost

Investing in factors involves codifying the rules and identifying the right opportunities. Therefore, the fund manager is not required to put much effort in managing the portfolio. Thus, the cost associated with factor investment is less than that of a traditional active investment strategy.

4) diversification

One issue you may have noticed is that when the market goes down, your entire portfolio is in the red. This is because you put all your eggs in one basket.

For example, you have only invested in companies based on market capitalization or specific sectors. The investment factor is landing a helping hand here.

When you invest in a multifactor fund, where the factors are less closely related, you end up with a well diversified portfolio.

So, when one factor is not working, another factor may work and you may be saved from falling victim to the market downfall.

5) Eliminate human bias

One of the problems with traditional investing is the presence of human bias. You can make the decision partly based on your judgment. You may end up investing in stocks that are underperforming, or you may avoid a stock that is already performing well.

Moreover, you may panic when the market goes down or you may be tempted when the market goes up. This usually happens in traditional investing because of human emotions.

You might argue that investing via mutual funds may eliminate this bias because the fund manager is clear about his or her investment strategies and objectives. We forget that even money is run by humans.

No matter how strategic the manager is, there are opportunities for bias. The investment factor solves this problem by avoiding human bias and qualifying stocks on the basis of reasoning.

Conclusion

In conclusion, factor investing is a more objective, systematic and straightforward approach to investing. When a traditional investing approach likely leaves you with market-like returns, lower diversification, and higher risk, factor investing comes to the rescue.

With factor investing, you are more likely to get a diversified portfolio with less exposure to risk and better returns.

(The author is Director (Strategy) at Estee Advisors and Head of Investments at Gulaq, part of the Estee Group)


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

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