The Indian financial markets have displayed remarkable resilience in recent years, even amidst a global macroeconomic environment fraught with uncertainty. This resilience can be attributed to a combination of the Indian economy’s strength and favourable policy actions aimed at achieving the ambitious goal of a $5 trillion GDP. Consequently, domestic investments in financial markets have surged, with monthly Systematic Investment Plan (SIP) flows in mutual funds exceeding INR 15,000 crore, accompanied by a growing influx of retail investors.

As markets mature and expand, they tend to become more efficient in pricing information, striving to reflect the fair value of stocks. This evolution has given rise to a phenomenon known as “Index investing” as the likelihood of active management outperforming benchmark indices diminishes. This shift was particularly evident in the Indian markets approximately five years ago when, in 2018, large-cap stocks drove market performance, resulting in more than 90% of mutual fund schemes underperforming benchmark indices like Nifty and Sensex. This prompted the emergence of Exchange-Traded Funds (ETFs) and Index Funds, as investors increasingly began to focus on “Alpha,” or the returns generated by funds in excess of underlying indices.

With the growing popularity of Nifty and Sensex Funds, fund houses such as Navi and emerging players like Zerodha have strategically positioned themselves within the index investing space, mirroring the trajectory of industry giants like Vanguard in developed markets.

Amidst the burgeoning index investing landscape in India, a sub-category is gradually gaining prominence—Factor-Based Index Investments. While this category has already established a firm foothold in developed markets with over $2 trillion in assets, it is still in its infancy in India. Leading asset management companies (AMCs) like ICICI, UTI, Motilal, and Nippon India have been among the early movers in this domain.

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To understand the concept of factor indices, we need to primarily focus on single-factor indices. Single-factor indices are a type of investment vehicle that tracks the performance of a specific factor, such as value, momentum, or size. These indices are relevant for investors who want to gain exposure to a particular investment style or strategy, such as value investing or momentum investing. 

Single-factor indices are created by applying a similar methodology to that used for popular indices like Nifty. The Nifty, for instance, is constructed by ranking all stocks by their market capitalization and selecting the top 50 stocks. Factor-based indices follow a comparable approach, except they focus on a specific characteristic of the stock universe. For example, the Nifty 200 Momentum 30 Index considers the “Momentum” factor, which involves analyzing the price trend over the past 6 and 12 months among Nifty’s top 200 stocks. Among these, the 30 stocks displaying the most robust upward momentum are chosen for the Momentum index.

Similarly, other factor indices are established based on distinctive characteristics, such as Value (comprising stocks with lower valuations), Quality (encompassing stocks with high profitability and strong balance sheets), and Low Volatility (consisting of stocks with the most stable price movements).

Investors can derive multiple benefits from factor-based investments, including:

Combining the Benefits of Active and Passive Management

Factor-based indices offer the advantages of passive investments, as they are governed by a set of predefined rules. Simultaneously, these indices are more active in terms of turnover due to their rebalancing rules, blending the benefits of periodic adjustments with rule-based governance to mitigate human bias. For instance, while the Nifty index’s turnover ratio over the past year has remained in the teens, with a performance of approximately 15%, the Nifty Momentum index has seen a turnover of over 100% and delivered a performance of around 24%.

Optimizing Investments According to Risk Appetite

As investors increasingly explore passive investments, factor-based indices provide a compelling means of diversification tailored to individual risk appetites. For example, conservative investors who typically favour the Nifty index can instead consider the Nifty Low Volatility index to reduce their exposure to risk.

Implementing Dynamic Strategies Aligned with Business Cycles

Active investors can employ factor indices to dynamically manage their portfolios in response to market cycles. During turbulent markets, Low Volatility and Quality indices can help protect against downside risks, while in rising markets, Value and Momentum indices can potentially generate alpha on the upside.

Enhancing Diversification through Strategy Bundling

Balanced investors seeking stability coupled with performance can explore the combination of strategies to leverage the advantages of different styles. Combining Low Volatility (low risk-return) with Momentum (high risk-return), for instance, can create a balanced portfolio that offers partial protection on the downside while being poised to capture gains on the upside.

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Maintaining Lower Expense Ratios

Factor index-based funds retain the cost-effectiveness associated with passive investing, offering allocation at lower expense ratios compared to active funds. This helps in constructing optimized portfolios for investors while minimizing costs.

In conclusion, factor-based indices represent a promising avenue for investors looking to navigate the evolving landscape of Indian financial markets. With their ability to blend the strengths of both active and passive approaches, factor-based indices offer a versatile toolset to enhance diversification, manage risk, and optimize returns in a dynamic investment environment.

As this segment continues to grow and evolve, investors would do well to explore the potential benefits that factor-based index investments can bring to their portfolios. By using a single-factor index, investors can gain diversified exposure to a specific factor, which can help to reduce risk and improve performance.

This article has been written by Vivek Goel, Co-founder and Joint Managing Director at Tailwind Financial Services, a wealth management platform. Views expressed are personal