Investors are increasingly turning to factor funds due to their ability to generate higher risk-adjusted returns. These funds invest in stocks based on factors such as value, momentum, quality and low volatility.
Factor funds, particularly multi-factor strategies, provide diversification benefits. This helps create more stable risk-adjusted returns, especially over the medium to long term. The one-year return from the top performing fund —UTI Nifty 500 Value 50 Index Fund— is 66%, followed by Motilal Oswal BSE Enhanced Value Index Fund at 65%. Even the low performing funds have given returns of 32-37%.
Factor funds offer a data-driven approach to portfolio construction, unlike traditional funds that depend on a fund manager’s expertise and track record. By combining multiple factors, investors can achieve superior wealth creation compared to traditional market benchmarks, making factor funds a viable long-term investment strategy.
Soumya Sarkar, co-founder, Wealth Redefine, AMFI registered mutual fund distributor, says since these funds follow specific strategies, they have the potential to outperform traditional funds by taking advantage of market trends and inefficiencies. “In the long run, the tailored approach of factor funds can lead to higher returns as they capitalise on distinct market dynamics that may be overlooked by broader market strategies,” he says.
Momentum, a key factor, selects stocks that show strong returns compared to peers. Nirav Karkera, head, Research, Fisdom, says while this factor can deliver high returns, it is prone to significant drawdowns in bearish markets. Combining momentum with other factors such as quality or value can smooth out volatility as these factors are often lowly correlated with each other.
How to choose a factor fund.
Investors should choose a factor fund based on the factor(s) that suit their investment objectives. For example, those looking for stability may prefer low volatility or quality-focused funds, while growth-oriented investors may opt for momentum or small-cap (size) funds.
Low volatility funds are typically better suited for investors with a moderate risk profile and a shorter horizon of three to five years, as they offer a more stable return profile. On the other hand, momentum or value-based factor funds, which are more prone to market swings, require a longer investment horizon of five to seven years or more to allow the strategies to fully play out.
Factors like value or momentum may exhibit cyclical performance. “Over longer periods, the benefits of factor premiums and compounding returns can significantly enhance portfolio performance,” says Anil Rego, founder, Right Horizons.
The investing horizon should be aligned with the long-term nature of factor premiums. Regular monitoring and adjustments can help ensure that the factor fund continues to fit the investors’ portfolio. Sonam Srivastava, founder, Wright Research, says factor funds are not immune to market volatility. However, some factors, such as low volatility, may provide a degree of protection against market downturns. “Investors should assess their risk tolerance, consider the fund’s historical performance, and diversify their portfolio across different factor funds and asset classes to manage risk.”
Characters of factors
Each factor has different characteristics. For example, value focuses on stocks that are undervalued relative to their fundamentals such as low price-to-earnings ratios. Momentum invests in stocks that have shown strong recent performance, with the expectation that the trend will continue. Quality targets companies with strong financials such as high return on equity, low debt. Low volatility prioritises stocks that have lower volatility compared to the broader market. Lastly, size focuses on smaller companies that have the potential for higher growth.