HomeMutual FundsFactor investing has emerged as a popular investment approach internationally, says Rajiv...

Factor investing has emerged as a popular investment approach internationally, says Rajiv Shastri of NJ AMC

Ever been in a dilemma while picking a restaurant for your birthday dinner?

One would generally shortlist restaurants based on some relevant attributes like the cuisine, location, cost, ambience and reviews. Similarly, investment professionals tend to select securities based on the presence and absence of attributes that commonly influence the risks and returns of securities. These attributes or parameters are formally known as investment factors and can be described as the drivers of risk and returns of securities.

Factor investing lies at the centre of the investment management spectrum, since it combines features of traditional active and passive investing philosophies. Factor investing, like traditional active investing, aims to outperform the market. At the same time, it benefits from the discipline and systematic approach of passive investing by using predefined quantitative rules. This approach of aiming to outperform the market by employing a purely quantitative rule-based investment methodology eliminates human bias at the execution stage and the resultant portfolios offer a well differentiated diversification opportunity for investors.

Since the risk and return of a stock depend on a vast number of attributes, can every such attribute be considered a factor? The short answer to that is “No”.

An attribute is formally accepted as an investment factor if and only if it is persistent, pervasive, intuitive, investable and robust. In other words, only those parameters that influence returns persistently over time, across sectors, geographies, and have an economic rationale can be considered as investment factors. In addition, gaining the desired exposure to the factor must be easy and cost-effective. Also, the parameter must work regardless of how it is defined, within logical boundaries.

Consequently, very few attributes have emerged as viable investment factors. Quality, Value, Low Volatility and Momentum are considered to be the most prevalent investment factors across the world as well as India. The Quality factor gauges the quality of a business and its management companies by assessing their profitability, growth, earnings quality and leverage. The Value factor aims to identify stocks trading at a discount to their intrinsic business values by comparing their market prices with fundamentals such as their earnings, sales, and/or cash flow on a per share basis.

Low Volatility and Momentum factors are based on the price behaviour of securities. The Low Volatility factor focuses on identifying stocks which generate more consistent returns while the Momentum factor selects stock that have exhibited the highest positive returns in the past to capture their continued rise.

NJ Quality 100 , NJ Low Volatility 100 and NJ Momentum 100 are portfolios using proprietary methodology developed by NJ Asset Management Private Limited. The methodology will keep evolving with new insight based on the ongoing research and will be updated accordingly from time to time.

Data provided in above is only for illustration purposes and should not be construed as a basis for investment. Please note that past performance may or may not sustain in future and is not an indication of future return.

As one can see from the above table, rolling 10-yr returns (CAGR) calculated by NJ Asset Management over the period October 2002 to May 2022 indicates that median returns Quality, Low Volatility and Momentum portfolios have beaten the Nifty 500 Index by more than 3%. Of these, the Quality factor stands out having generated the highest median 10 year rolling CAGR followed by Momentum, Low Volatility and Value. Point to point returns provide some more clarity on these performances.

The Value factor has periodic lags in its performance compared to the index. One such episode was seen from 2018 to 2020 which undid a lot of the benefit it had accumulated over the preceding decade, as visible from the chart above. However, it has recovered some lost ground through 2021 and till date in 2022 as well.

As one can also see, over shorter periods of time, individual factor performances can be quite inconsistent. By themselves, the Momentum and Value factors are quite volatile while Quality and Low Volatility aren’t. Individual factors can also underperform the index significantly in many time periods while generating significant excess returns in others. As such, a single factor portfolio or a portfolio dominated by any one factor can prove to be quite challenging for most investors in terms of returns, volatility or both. To overcome these challenges, a multi-factor portfolio that selects stocks based on more than one factor has proved to provide a balance.

Known by any names such as smart beta, strategic alpha etc., Factor investing has emerged as a popular investment approach internationally, gaining assets at the expense of discretionary active funds. In India, the paucity of credible data could delay its advent for a few years but with high quality corporate data spanning more than three market cycles now available, this is certainly an idea whose time has come.

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