Investment word of the day: An investment approach that chooses securities based on specific characteristics that determine risk and return is known as factor investing. It aims to boost returns, manage risks and enhance diversification by strategically focusing on particular factors.
Types of factors
The two major types of factors that influence investments are macroeconomic factors and style factors.
Macroeconomic factors include a broad range of risks across various asset classes. Some common macroeconomic factors are inflation, GDP, and the unemployment rate.
Style factors focus on returns and risks associated with specific asset classes. These factors include value, growth, low volatility, quality and momentum.
Components of factor investing
1. Value: The value factor is based on the idea that businesses with lower valuations typically generate higher returns.
2. Quality: It is generally characterised by manageable debt, steady earnings, and consistent asset growth. Investors can recognise quality stocks through standard financial metrics such as return on equity, debt-to-equity ratio, and earnings volatility.
3. Momentum: This factor suggests that stocks that previously performed well are likely to maintain this performance relative to their peers.
4. Volatility: It is believed that stocks characterised by low volatility tend to yield higher risk-adjusted returns compared to those with high volatility.
Significance of factor investing
According to Siddharth Maurya, Founder and CEO of Vibhavangal Anukulakara Private Limited, “factor investing allows both institutional and retail investors to break free from the confines of active, passive, or hybrid investment strategies to adopt a more structured and scientific approach to investing.”
One of the major advantages of factor investing is portfolio diversification to avoid risks.
“Enhanced portfolio diversification is one of the most essential benefits of factor investing. By focusing on separate uncorrelated factors, it helps investors avoid the downside risks linked with a market decline or downturn while improving risk-adjusted returns,” Maurya said.
“Moreover, the value and quality factors have demonstrated outperformance over extended periods, supporting this strategy for long-term wealth accumulation. Additionally, it enhances discipline and transparency by lessening the burden of emotional or irrational tendencies through the rules-based approach,” he added.
Disadvantages of factor investing
There are some factors that an investor must consider before opting for factor investing.
According to the expert, Factor-investing strategies may experience short-term lacklustre performance. For instance, value strategies often underperform during growth-oriented market phases. Additionally, there is a risk of crowding, where the effectiveness diminishes due to an excessive number of investors targeting a single factor.
He further asked investors to comprehensively analyse how each of the factors behaves in various market environments, which introduces complexity and requires constant reevaluation.
In conclusion, while factor investing aims to enhance portfolio performance and risk management, it requires careful attention and diligence.
Disclaimer: This story is for educational purposes only. The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.
