The utility of factor investing in building your equity portfolio

The success of a movie at the box office can be attributed to a combination of factors, including a star-studded cast, an engaging storyline, high-paced action sequences, impressive visual effects, etc. Similarly, the returns of an equity portfolio can be attributed to various factors such as market capitalization (m-cap), momentum, value, quality, and volatility.

Typically, the majority of Indian mutual fund investors focus on one factor—size or m-cap, which is measured by multiplying the number of a company’s outstanding equity shares by the current market price of each share. This denotes the total value or ‘capitalization’ assigned by the entire market to that company. The largest m-cap companies are usually the largest, on parameters like top-line (sales), book value, cash flow, dividend payouts, etc. The largest m-cap companies have the highest liquidity in the stock market, due to their large investor base. M-cap and traded liquidity are strongly correlated, meaning that capitalization weighting prioritizes stocks traded more frequently, resulting in lower portfolio transaction costs or impact costs.

However, capitalization weighting inherently allocates a higher proportion of investments towards stocks that are discovered by the market and valuation is fair or on the higher side. This approach simultaneously assigns lower exposure to stocks that are arguably undervalued. As an indication, of our total stock m-cap of ₹273.5 trillion as on June this year, 68.3% is in large-cap stocks (top 100 stocks), 16.6% is in mid-cap stocks (101 to 250 stocks) and 15.1% is in small cap stocks (beyond 250).

Another issue is that all m-cap approach portfolios, including large-, mid-, and small-cap, are correlated, offering lesser diversification to investors within the equity portfolio. This provides an opportunity for investors to allocate based on other factors such as momentum, low volatility, value, and quality, which have low correlation across different market cycles. The mutual fund industry has launched various factor-based funds that track different Nifty indices, such as momentum, low volatility, quality, and value.

Now let’s define the factor-based index strategies to understand how stocks are classified, based on each factor. ‘Nifty200 Momentum 30’ Index aims to track the performance of the top 30 companies within the universe of Nifty 200, determined based on its past six-month and 12- month price returns, adjusted for volatility. The Nifty Low Volatility 50 Index aims to measure the performance of the least volatile stocks based on standard deviation of daily price returns for last one year. Nifty100 Quality 30 index includes top 30 companies from its parent Nifty 100 index, selected on quality scores based on return on equity (RoE), financial leverage (debt to equity Ratio) and average change in earnings, that is EPS (earnings per share) growth, analysed over the previous five years. The Nifty500 Value 50 index consists of 50 companies from its parent Nifty 500 index, selected based on their ‘value’ score determined on earnings to price ratio (E/P), book value to price ratio (B/P), sales to price ratio (S/P) and dividend yield.

In different market cycles, some factors are more dominant than others, and every factor has its own cycles of outperformance and under-performance in markets, vis-à-vis the broad indices. The momentum factor tends to significantly outperform in bull market cycles, while quality and low volatility factors offer good downside protection in bear markets. The value factor tends to outperform when the market is recovering from a bear market phase.

Factor timing, just like market timing, is difficult without the benefit of hindsight. Thus, through a multi-factor approach to investing, the investor can reduce factor-specific risks. This can be done, without compromising on long-term performance, providing for better risk-adjusted returns. Investors, based on their, market view could add a particular factor to the existing portfolio to amplify returns (momentum index) or to reduce volatility (low volatility index). Factor-based indexes can be useful additions to the equity component of investors’ portfolios. There are mutual fund products tracking these indices. Hence, by buying one unit of the fund, you are buying into a portfolio mirroring the relevant index. Factor investing sits somewhere between active and passive investing and seeks to combine the best of both worlds. The objective here is not so much to generate alpha (outperform a popular index) but to work on smart beta-better risk-adjusted returns.

Joydeep Sen is a corporate trainer (financial markets) and author, and Harsimran Sandhu is professor and area chair (finance), IMT Ghaziabad.