Riding the Business Cycle Through Factor Investing

Factor investing is being embraced as the third style of investing, going beyond active and passive investment

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The issues inherent in the actively and passively managed strategies have been instrumental in the rise of factor investing. Actively managed strategies are usually conviction driven allocation, thus leading to biases sometimes and attract high fees than passive; in their quest to deliver better than benchmark returns. However, this is not always true as in India today, most of the large-cap actively managed fund is finding it difficult to outperform the benchmark. The passively managed strategies benefit from the low-cost structure and transparent investing, however one has to accept lower returns usually. While investing in the Nifty 50 Index Fund or ETF, is an example of a passive strategy, one will never be able to outperform the Nifty 50 Index due to expenses.

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Factor investing is being embraced as the third style of investing, going beyond active and passive investment. It seeks to combine the benefits of both passive investing and active investing strategies. The goal of this strategy is to obtain alpha, increase diversification at a cost lower than traditional active management albeit marginally higher than straight index investing.

Evolution of smart beta funds

There has been a lot of research and work done globally on this already, like identifying over 300 factors and tracking their performance for decades. In laymen's term, a factor is any characteristic that explains the risk and return of a group of securities. There can be single or multiple factors toanalyse, explain and build investment strategies. There are various approaches to use factors in investment strategy, commonly labelled "Smart Beta", which has gained considerable traction in recent years. Smart Beta is a simple and transparent form of factor investing.

Across the globe, factor investing has rapidly gained popularity and been embraced by all, from the large institutional investor to savvy UHNI/HNI, family offices and retails investors. Smart-beta funds are more popular globally withthe $1.12 trillion worth of investments according to ETFGI's March 2021 ETFs and ETPs Smart Beta industry landscape insights report.

Different factors display strengths and weaknesses in different economic and market environments, with one factor outperforming in one environment and the other doing better in another environment. Nifty factor indices provide a basket of stock with pre-defined, homogeneous risk and return attributes.

Some of the common single factors are quality, value, alpha and low Volatility. A combination of two or more factors results in multi factors like quality-low volatility and alpha-quality-low volatility. As Andrew Ang, a pioneering academic advocate of factor investing from Columbia University put it: "Just like "eating right' requires you to look through food labels to understand the nutrient content, "investing right' means looking through asset class labels for the underlying factor risks. It's the nutrients in the food that matter. And similarly, the factors matter, not the asset labels."

Our in-house analysis suggests that single factor Nifty Alpha 50 consistently performed well across various upcycles, (CAGR - 17.6 per cent Vs 12.2 per cent of Nifty 50 since 2005), followed by single factor Nifty 200 momentum 30 (CAGR - 17.8 per cent Vs 11.9 per cent of Nifty 200 since 2005). While multi factor Nifty Alpha Low Volatility 30 delivered highest CAGR of 18.4 per cent since 2005 amongst all factor indices.

Factor-based indices have yielded higher risk-adjusted returns as compared to broad indices returns across the time horizons.

Nifty Alpha 50 has mostly outperformed all the broader indices, other single and multi-factor indices, across tenures albeit with higher volatility. Nifty 200 Momentum 30 is the second-best overall performer in the medium to long term, with volatility closer to the broader indices. In the long term, Nifty Low volatility 50 & Nifty 200 Quality 30 stood out of the pack and have fared well in the midterm as well with volatility lower than the broader indices.

All the multi-factor indices have lower volatility and have a better return profile in the long term in comparison to the broader market indices. All have done reasonably well; however, Nifty Alpha Low Volatility 30 has delivered better returns than other multi factor-based indices at relatively higher volatility.

The table below shows the performance and volatility of the broader and factor indices across time horizon.

Performance of Factors w.r.t Benchmark