By Sukanya Ghosh
Factor investing is popular due to its transparency, disciplined investment thesis and the ability to construct diversified portfolios. This approach provides an alternative to traditional cap-weighted benchmarks.
We often forget that watching market dynamics through the lens of factors is a complementary approach to the macro-economic cycle. It can help better understand patterns, systematic behaviour of a category of stocks or sector. Identifying market regimes and understanding equity factor performances provide opportunities to time the market.
The four factors
Equity factor based investing is premised on a portfolio of securities mimicking a defined style. For example, value factor is a portfolio of low valuation stocks while momentum factor is a portfolio of stocks exhibiting the highest returns among peers over a defined period. The most common factors are value, quality, momentum, and growth.
Globally, value dominated the early decade of the century. In 2021-22, value made a comeback, after a decade of dominance of momentum and growth. Quality, being a defensive factor, outperformed during the global financial crisis. Notably, factor rotation has increased over the last decade compared to the previous decades.
This brings us to Indian markets and whether factors in India work alongside global factor performance. India has, predominantly, been a market where growth and quality factors have outperformed for extended periods of time. They, however, work in different market regimes.
Quality is, typically, the top-performing style when markets are down. Growth style focuses on investing in companies which display a higher earnings growth. Market return is, usually, higher when growth style outperforms.
Just after the global financial crisis, Indian markets saw a sustained period of quality outperformance, which was contrary to global markets. But the return of value style in 2021-22 was across most markets, including India.
Quality is less volatile
Do these factors have unique risk return characteristics? Quality is a less volatile factor which performs when markets are falling. On the other hand, value and growth are factors that capture a larger upside in rising markets.
This year, we have witnessed the incredible value-run change course. Quality style has rebounded, outperforming other factors. A multi-factor approach to investing ensures diversification, helping to smooth out the volatility of individual factors. This also helps in mitigating large drawdowns during market downturns.
A deeper understanding of investment style characteristics across various market regimes helps us to align our portfolios to our market outlook. This reduces our vulnerability to market volatility. In every regime, a few styles outperform the others. Eliminating biases towards a certain style and investing according to the current market regime aids in smoothening the portfolio management process.
The writer is fund manager, SBI Mutual Fund