Money
Mint Explainer: What are factor funds and how do they work?
Summary
- Discover the emerging world of factor funds—an innovative blend of passive and active investing. Learn how these rule-based funds use specific criteria to select stocks and why they can help navigate volatile markets.
In recent years, passive investments have seen a meteoric rise in popularity. According to data from the Association of Mutual Funds in India (Amfi), the share of passive funds in the mutual fund industry had surged to an impressive 17.5% as of March 2024 from 7.4% in March 2020. But there’s a fascinating middle ground emerging between passive and active management: factor-based funds.
Unlike traditional passive funds that simply track an index, factor-based funds operate on predefined rules or criteria—related to fundamentals or stock behaviour—to select stocks. These funds don't have a fund manager making investment decisions, yet they aren’t as straightforward as index trackers. They rebalance at regular intervals, typically every six months, to ensure alignment with their specified factors.
Single or Multi-Factor: Which is better?
Factor funds use a variety of criteria such as momentum, value, growth, quality, and low volatility. They can be categorized into single-factor funds, which focus on one specific factor, and multi-factor funds, which combine several factors in varying proportions.
Experts argue that multi-factor strategies can be more effective.
Read this | The perennial debate in factor investing: Quality versus value
“For example, a combination of momentum and low volatility can be a good strategy, as the latter can mitigate the downside risk of a momentum strategy during bear markets," says Kavitha Menon, founder of Probitus Wealth.
Menon emphasizes that factor performance should not be viewed in isolation and that investors need to exercise caution when selecting these factors.
“One must consider the universe of stocks that the factor is applied on. For instance, the last few months momentum funds have outperformed. This may be due to their underlying universe which is mostly mid-caps and small-caps. As the underlying has seen a bull market, the factor too has done well. When the performance of this universe reverses to mean, momentum may swing downwards and cause deeper corrections," she explained.
How do factors perform in different market phases?
The performance of different factors can vary significantly across market phases. For instance, the quality factor performed well in 2021 but was the worst performer in 2022.
Bhavesh Jain, co-head of factor investing at Edelweiss Mutual Fund, explains that predicting which factor will perform well is challenging due to rapidly changing market dynamics. Therefore, a multi-factor strategy can help eliminate bias toward any single factor.
Fund houses typically follow specific styles and investment philosophies, leading to stock picks that may be value-oriented, growth-oriented, quality-oriented, or momentum-driven. This explains why funds from certain houses may underperform during some market phases and outperform during others. For example, while growth investing was dominant for a while, recently, value-driven strategies have taken the lead.
More here | Should you invest in Mirae’s latest multi-factor small-cap fund?
Growth investing focuses on companies expected to grow at an above-average rate compared to others, prioritizing future potential over current valuations.
Factor-based funds aim to eliminate human or fund manager bias by strictly adhering to predefined factor-based signals. This approach seeks to provide a more systematic and objective method of stock selection.
Which factors should you choose?
Depending on your risk appetite and return expectations, you can choose a combination of factors or even single-factor funds. If your portfolio already includes active funds with a particular investment style, a specific factor-based fund can complement it. For example, if you hold an actively managed value fund, adding a growth-factor fund can provide diversification and vice-versa.
For a multi-factor fund, strategies that combine momentum and low volatility are worth considering. If you prefer to avoid these price-based factors, fundamentals-based factors like value—which seeks reasonably valued or undervalued stocks with strong fundamentals—can be a good choice. However, it’s crucial to consider the universe of stocks the factor fund is based on, whether large-caps, mid-caps, or small-caps.
Also read | Should you invest in this scheme that’s quietly topping the charts?
In conclusion, as the landscape of passive investing evolves, factor-based funds offer a unique blend of passive and active management, providing more options to investors to build strategies to navigate changes in market dynamics.
