Stock markets: Know how factor investing works

Published: August 14, 2019 12:40:49 AM

Allocating investment capital to factors could be a better way to diversify rather than allocating across asset classes as it will help to reduce risk and increase returns

The BSE and the NSE have launched the factor indices at the end of 2015 and the middle of 2017, respectively after MSCI launched the world factor indices. (Illustration: SHYAM Kumar Prasad)The BSE and the NSE have launched the factor indices at the end of 2015 and the middle of 2017, respectively after MSCI launched the world factor indices. (Illustration: SHYAM Kumar Prasad)

By Nehal Joshipura

While diversification is a powerful tool to reduce the risk of your investment value going down, it is necessary that you diversify your investments across avenues not tied together. If you have diversified across stocks and bonds, these may face the same impact in some macro-economic scenarios taking everything down during a sharp market fall.

The BSE and the NSE have launched the factor indices at the end of 2015 and the middle of 2017, respectively after MSCI launched the world factor indices. These established factors include value, momentum, size, volatility and quality factors. Allocating investment capital to factors could be a better way to diversify rather than allocating across asset classes in a world where the asset classes have a high correlation. Factors help to meet your objectives such as reducing risk, increasing returns, and increasing diversification by providing a better understanding of risks and returns.

We can attribute the stock return to many factors. But academic literature has historically identified critical drivers of portfolio risk and return that have a systematic impact on the stock returns across markets. These factors have their own reasons to persist and understanding the direction of their effect is quintessential for being a successful equity investor.

This article demystifies factor investing.

Value investing
Value investing is buying value-creating stocks at a relatively inexpensive valuation and waiting for the price to converge to the fair price. As per the evidence documented in academic literature, value stocks portfolio out-perform the growth portfolio over the longer duration or full market cycle. So, to simplify, value investing creates positive alpha. However, the last decade has delivered little for the value investors. Value stocks can be identified by looking for lower valuation ratios like price-to-earnings and free cash flows. Value investors need to beware of falling knives while searching for the hidden gems.

One way to differentiate between them is Piotroski F-Score, that helps assess the strength of a company’s financial position.

Momentum in buy/sell
Momentum is buying the winners and selling the losers. Momentum investors believe that past good performance will continue over the near-and medium-term horizon. Value strategy is more intuitive as it suggests buying at the dip and waiting for the gains over a longer time. Momentum investing is to buy stocks that have run up as over the medium-term horizon, the trend should continue. This may lead to higher portfolio churn while giving higher returns. We can identify high momentum stocks using the last 12-month returns.

Size factor
Size factor captures the return premium for the smaller companies over large companies. Originally, it was claimed that small stocks outperform large firms. However, most emerging markets have seen a reverse pattern in the recent past and the Indian market is no different. Small firms’ premium was explained by excess risk for smaller businesses. Therefore, we see higher volatility in smaller stocks. Size factor does not create a very strong effect. Proxy for size is market capitalisation.

Low volatility
Contrary to theory, low-risk stocks beat the high-risk stocks and the overall market. This anomaly is persistent. The reasons for explaining it include investor biases and fund managers’ constraints. The risk can be measured by using the standard deviation of returns, beta or idiosyncratic volatility. This defensive factor achieves alpha by losing less during the range-bound or sliding down market cycle. We can combine this factor with any factor capturing returns in the upmarket.

Quality factor
Quality factors are durable business models and sustainable competitive advantages. In 2012, Robert Novy-Marx published a pioneering paper that found profits and stability, i.e., quality, were just as useful for explaining returns as traditional value measures. Quality factor captures return premium generated by companies with low debt, stable earnings growth, etc. These companies have strong financials and good corporate governance. This factor may have some overlappings with factors such as value and low volatility. Unlike value investing, you don’t look at valuation here. Like low-volatility, quality is categorised as a “defensive” factor, meaning it has benefited during periods of economic contraction.

To combine these factors in a portfolio, one should understand their reaction to the market cycles. Defensive factors such as low volatility and quality will perform better during range-bound or declining markets. Pro-cyclical factors such as value and small size will outperform during rapidly climbing markets. Momentum performs well during stable market conditions and should be combined with low-volatility or value factor.

The writer is a SEBI registered investment advisor

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