Factor investing for alpha returns: Here’s how your passive portfolio can gain more than Sensex

Momentum factor has returned 19.9% annualised gains over the last 10 years; low volatility factor 18.4%; quality factor 18%, beating Sensex, which returned 15% in the same period.

Someone investing in a multifactor portfolio in the Indian market over a period of 10-15 years can expect 3% outperformance (REUTERS)

A passive investment portfolio of factor strategies could return as much as 3 percentage points more than a headline index such as Sensex over a long period of time. Over the last 10 years, momentum, low volatility and quality factors have beaten S&P BSE Sensex by up to 5 percentage points. More recently, this year, the value factor has returned nearly triple the Sensex, after years of outperformance. Tianyin Cheng, Senior Director, Strategy Indices, S&P Dow Jones Indices, shares how to build an index-beating passive investment portfolio, in an interview with Shaleen Agrawal of Financial Express Online.

Momentum factor has returned 19.9% annualised gains over the last 10 years; low volatility factor 18.4%; quality factor 18%, beating Sensex, which returned 15% in the same period, Cheng said citing empirical results of S&P research. The value factor long underperformed until mid last year where trend changed to a more value driven market. This year, value has delivered 55% return (YTD) where the broad market has given around 20% (YTD), she said.

Risk, return over long period

Someone investing in a multifactor portfolio in the Indian market over a period of 10-15 years can expect 3% outperformance, Cheng said. Research showed that over the period from October 2005 to June 2017, portfolios for all factors – low volatility, momentum, value, quality, dividend, and size – outperformed the S&P BSE LargeMidCap, Cheng said citing the “Factor Performance Across Different Macroeconomic Regimes in India” report. Only low volatility, quality, and momentum delivered better risk-adjusted return (return per unit of risk) than the S&P BSE LargeMidCap.

Among the six factors, low volatility and quality recorded lower return volatility than the benchmark and had the highest risk-adjusted return, while value, dividend, and size showed much higher return volatility than the benchmark. However, there are cycles, she said, citing the example of value factor, which turned around last year.

Hold single factor portfolios for longer time

For investors holding on to single factors, Cheng advised holding on for a longer period of time keeping in mind that the factor may underperform for a significant period of time but overall, it will outperform. While all factors outperform, they outperform in different ways. For instance, low volatility has a beta of less than 1 compared to markets meaning it does not spike as much when the markets are going up but it also provides protection when markets are going down. So, one can invest in it from a risk protection point of view.

Factor investing not just for returns but for risk management

Aside from apha returns, investors can invest in factors for risk management. Investors who have already allocated to core equities can consider investing a part of their portfolio in factors that can potentially outperform and deliver the Alpha. For retail investors, factor investment can be an excellent tool for expressing their market view. Due to the strong defensive characteristics of quality and low volatility, they are potential factor strategies to minimize downside risk.

Factor performance across market cycles

During bear markets, quality and low volatility were the best-performing factors, outperforming the benchmark more than 70% of the months, while value was the worst-performing factor in this phase. During recovery periods, value, dividend, and size generated the highest excess returns, while low volatility had the worst performance. In bullish markets, only the momentum factor delivered significant excess returns. The factors that delivered the most favorable return in each bullish, bearish, and recovery period between 2005 and 2017.

For Alpha returns: Diversify with Multi-factor portfolios and Consider timing factor

While single-factor smart beta strategies tended to outperform the market over the long term, they experienced periods of underperformance at different macroeconomic conditions, depending on their cyclical characteristics. Cheng emphasised that multi-factor portfolios are better as with single factor portfolios you never when they are going to bounce back if they have been long underperforming. On the other hand, blending factors in a portfolio to diversify factor exposure may help deliver smoother excess returns across business and market cycles, with the effectiveness depending on the correlation of returns among factors.

As per the research report cited above, over the long run, excess returns for dividend, value, and size were highly correlated, while low volatility had the most negative excess return correlation with the value and size factors. Quality versus dividend and size are the most uncorrelated pairs among all the factors. There are different approaches to combining factors in a portfolio that aim for various objectives, which is what investors need to focus on in order to reap Alpha returns.

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