What is Factor Investing in Mutual Funds, and how does it work?
Markets have scaled to new heights. With the new IPOs taking the market through a new ride, the investors are now in a dilemma regarding their portfolio structures. Investors are worried about which sectors to target to invest in the right stocks at the right time and avoid losses while continuing to gain. Further, the advent of new funds – factor-based funds – is making its way into investor portfolios. Factor-based funds are inspired by a unique style of investing, known as factor investing, also called the Smart Beta investing.
Here is an overview of factor investing in mutual funds and how it works:
What is factor investing in mutual funds?
Factor investing is a type of strategy where the mutual fund manager identifies securities according to patterns or factors common to all securities for returns across assets. For instance, a value-based investment approach aims to identify companies with the lowest valuations. Here the aspect used for investment is ‘Value’. There are two types of factors used in factor investing – macroeconomic and fundamental.
Macroeconomic factors specify risk across asset classes, such as business cycle risk, interest-rate movement risk, inflation risk, credit risk, political and sovereign risks, and liquidity risk. These factors help with the broader asset allocation (such as debt or equity). Fundamental factors include value, minimum volatility, momentum, quality, size and carry. These factors help identify specific equity securities as per the factor considered.
Factor investing in mutual funds reduces volatility, improves portfolio returns, and enhances diversification.
How does factor investing work?
The returns of an equity mutual fund portfolio comprise market returns or Beta, directly attributed to the market and excess returns or Alpha, returns generated because of the investing style of the fund manager. Market returns apply to all investors, and the difference in portfolio performance comes from the Alpha returns, which can be positive or negative.
Factor investing is about finding the right factors or features that persist over time and can contribute towards positive portfolio performance. These features or markers, such as size, profitability, financial ratios, etc., are not specific to any industry, business, or company. These features depend on the phase of the economy or the market, and can even alter with the life stage of the company. These factors can emerge and vanish over time.
The mutual fund manager starts with a broad set, such as NSE 500 companies, and ranks them based on a factor, like the lowest price value. Therefore, the company with the top rank will have the lowest price value and vice versa. Similar factors that the fund manager could use to create a mutual fund portfolio include Growth (high earning per share (EPS)), Dividend Yield (market price or dividend paid), etc.
Overall, factor investing is one of the fastest-growing investment themes in the mutual fund space. This strategy is cost-efficient, transparent, less risky, and reduces long-term investing bias. This modern and statistically proven approach is a smart strategy to manage your mutual fund portfolio.
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