Understanding factor investing in equities through a different lens
This article is authored by Neha Agarwal, Vice President of Research at SageOne Investment Managers LLP
Factor Investing is an investment strategy that involves capturing specific attributes or factors through multiple approaches. The concept emerged from the theory of Efficient Market Hypothesis (EMH) by Eugene Fama in his publication in 1970.
As per EMH, current stock prices capture all the existing available information, making them fairly valued all the time. This is also the premise of passive investing through index funds or exchange-traded funds (ETFs) to achieve returns that mirror the overall performance of the market index being tracked.
However, in practicality (especially in emerging markets like India), there is a wide disparity between access to information and timely reactions, and it can be readily seen that investors do not always act rationally. This means that equity markets, in practice, do not trade efficiently. The pace at which any new information could get captured would vary across market capitalisations.
On top of that, the collective emotions of market participants in the form of greed or fear, variation in market liquidity etc. precipitate market inefficiencies at regular intervals. At the same time, such inefficiencies contribute to creating opportunities for generating higher alpha through active investing.
Factor investing is seen as a "third way" between passive and active investing. It aims to outperform the market by targeting specific factors in a rules-based, transparent, and low-cost manner. The main factors which meet the criteria of being well-rewarded, persistent, and academically backed are value, momentum, low volatility, and quality.
It can be implemented through smart beta or factor-based ETFs. (In the Indian market, the National Stock Exchange or NSE has introduced several factor-based indices such as NIFTY LOW VOL 50, NIFTY200 MOMENTUM 30 etc)
However, factor-based ETFs also carry the risks of over-exposure to specific factors, reliance on unpredictive historical data and potential underperformance if not implemented properly. Hence, it is important to identify factors which align with one’s investment objectives and risk tolerance levels.
Active investment managers, employing their investment strategy, are also inclined towards specific factors at any specific juncture. What makes them more effective in the long run is their ability to align themselves to different factors as per their expectations of market behaviour at different times. Combining broader macroeconomic factors (using a top-down approach) with a detailed analysis of individual stocks (employing a bottom-up approach) can result in a portfolio that embraces a multi-factor strategy.
By identifying key macroeconomic drivers and their positive influences on specific sectors or industries, followed by pinpointing financially robust businesses well-positioned to capitalize on these trends, investors can capture a range of factors simultaneously. Such a dynamic approach to factor investing could be a more sustainable way to participate across market cycles and periods.
We must still take note that behavioural biases can hinder fund managers' agility across factors. Biases like overconfidence, loss aversion, and anchoring make it difficult for managers to assess market changes objectively and adjust factor exposures accordingly.
Hence, it is necessary to assess the merits and limitations of all investment approaches and select one that best suits individual investment goals.
Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.