Your Money: Factor investing can help reduce risks

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By P Saravanan

Indian stock markets have outperformed all the major global equity markets over the past year, demonstrating a strong and resilient performance. Given the resilience in the markets, investors should take advantage of it. At the same time, diversification can reduce the risk of investment value falling. One way to reduce the investors’ risk is factor investing.

What is factor investing?

A factor investment strategy involves selecting assets according to factors and attributes that are of interest to the investor. Stock returns are determined by these attributes. “Factors” are characteristics of a stock that offer a competitive advantage. There are two types of factors involved: macroeconomic factors and style factors. Macro-economic factors include economic growth, inflation, interest rates and political risk.

Style factors means asset specific volatility, momentum, etc. These factors have a significant impact on each asset class and its return. Factor investing focuses on factors by optimising the portfolio by inclusion or exclusion of factors so that the assets produce favourable long-term returns. The objective of factor investing is to construct an investment portfolio based on a single or a combination of factors. There have been many advances in factor investing over the past few decades, including the evolution from being only market- and company-specific to a variety of other factors.

What are the merits?

The first and foremost benefit is the diversification provided by factor investing which minimises the risk exposure of a portfolio. Because a variety of macroeconomic and style factors is considered to improve diversification, generally they produce better returns. To get the maximum return from this, one has to consider investing in a multifactor fund wherein the relationship among the various factors is minimal, thereby making it more immune to shocks. Further, factor investing increases the transparency of the investing process.

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This can be attributed to the fact that reasons for performance of stocks can be easily identified in factor investing while in traditional investing, reasons for poor performance of the fund / portfolio remains unknown to the investors. With regard to portfolio performance, the efficiency is increased because in factor investing, stocks are selected strategically based on specific characteristics that are desirable and are free from any human bias. Therefore, factor investing offers relatively high returns as it focuses on a stock’s / asset’s traits that have historically produced positive returns.

What are the limitations?

Despite the fact that factor investing appears quite safe and attractive, it is not without any limitations. Factor investors should exercise caution because they might expose themselves to greater risks since factors are often viewed only from the standpoint of their benefits rather than their inaccuracies. Factor investing relies mainly on data and hence selection of sample plays a great role in modelling the portfolio and hence it is not free from selection bias. Moreover, relying solely on only a selected few factors as a basis for investment strategy entails many risks.

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To conclude, factor investing helps in enhanced portfolio diversification based on strategies. As a safety measure, portfolio diversification has long been popular, but if the selected securities follow market trends, the diversification benefits are lost. Investing in factors, on the other hand, can mitigate potential risks by focusing on long-term, widespread, and well-established investment factors. Many mutual fund houses are offering a variety of factor-based funds and one can consider allocating a portion of their investment either in factor investing funds or follow the strategy while creating one’s portfolio.

The writer is a professor of finance and accounting at IIM Tiruchirapalli