Factor investing versus others

The financial markets are constantly evolving and the advancement of technology, especially in machine learning and enhanced power of computers is leading to new investment strategies backed by empirical research. Professional investors are gaining a better understanding of security price behaviour and performance drivers these days.

Factor investing

One of the recent innovations in the investment world is factor investing, which tries to target specific attributes of securities. Some of the most-used factors are value, momentum, small stocks and low-risk stocks, which tend to outperform the market on a risk-adjusted basis. The popularity and acceptability of the factor investing can be gauged by the rise of asset under management of the funds using ‘factor’ as their portfolio building criteria. According to Morningstar, the assets under management for factor and smart beta strategies grew from USD 280 billion in 2012 to USD 999 billion at the end of 2017, which translates into an annual growth rate of 29 per cent.

The number is expected to reach close to USD 1.5 trillion by 2021, according to Citi Bank and Morningstar.

Factor investing and others

From a mutual fund perspective, factor investing lies between the active funds and index funds. In case of active funds, its manager aims to outperform the market by buying or selling individual or a portfolio of securities that may or may not differ from the benchmark. For example, most of the equity-dedicated funds other than index funds and ETFs are active funds. While a conventional index fund tracks an index, which reflects the market or a market sector as a whole. The fund manager does not play a prominent role in an index fund whereas, in case of active funds, the fund managers play quite an important role.

Factor-based funds such as environmental, social and governance (ESG) fund, try to harvest a premium over market capitalisation index with a specific or a combination of investment styles over the long-term. So, an ESG fund can invest in companies from the top 100 in terms of market-cap (or BSE 100), which exhibits higher ESG factors. Therefore, factor investing has a combination of both active management (finding companies with higher ESG factor) and index (BSE 100) worlds. So, the factor investing is positioned between active styles and traditional indices. Even the expense ratio of such funds are somewhere between the active and traditional index funds.