Factor investing: What is it and how does it work?

Investing is about making informed choices to potentially grow your wealth, but the market’s complexity often requires a deeper understanding of what drives returns. This is where factor investing comes in – a methodical approach that focuses on specific traits of stocks to build a portfolio.

Factor investing is a strategic approach that focuses on specific ‘factors’ or qualities, that drive returns. These can include their growth trajectory, volatility and market valuation, among others. This article tells you more about factoring investing, how it works, and why its gaining popularity among investors.

Table of contents

• What is factor investing?
• Types of factors
• Key factors in factor investing
• History of factor investing
• Why factor investing matters
• Advantages of factor investing
• Disadvantages of factor investing
• The future of factor investing

What is factor investing?

Factor investing is an investment approach that uses specific characteristics or “factors” to pick stocks. These factors are qualities that explain why some stocks or portfolios perform differently than others. Simply put, factor investing is about identifying and focusing on what works in the stock market.

For example:

• Low volatility: Stocks that move less up and down can provide relatively stable return potential
• Value: Stocks that are undervalued compared to their earnings, assets or other fundamentals may give superior long-term returns if the market recognises their value.

Rather than relying on guesswork, factor investing uses data and research to choose stocks with these qualities.

Types of factors

Factors that influence investing can be of two broad types:

Macroeconomic factors

These are big-picture factors that affect the overall market and economy. They include broader economic indicators such as inflation, interest rates, currency movements and economic growth. Macro factors influence entire sectors and markets rather than individual stocks, making them critical for long-term investment strategies.

Style factors

These are smaller, more specific factors that focus on individual stocks or assets. Examples include value, growth, low volatility, quality and momentum. Style factors are widely used in factor investing strategies because they help identify the specific qualities that drive stock performance. Style factors are most commonly used in factor investing because they provide targeted opportunities for potentially generating higher returns than the broad market and managing risks. By combining style factors, investors can create balanced portfolios tailored to their goals, such as low volatility, growth or potential for income.

Key factors in factor investing

Here are some of the most popular factors used in factor investing strategies:

• Value: This approach focuses on finding stocks that are undervalued compared to their fundamentals (like earnings or assets). These stocks are expected to potentially generate better returns when their value is recognised. Value investing helps investors find hidden opportunities in undervalued companies and buy their stocks at lower prices.
• Momentum: This style of investing identifies stocks that have performed well recently. The idea behind this is that stocks that are rising may continue to rise for a while. Momentum strategies capitalise on trends and investor behaviour and can deliver better returns in the short-term till the momentum continues.
• Low volatility: Low volatility focuses on stocks that typically fluctuate less. These stocks have the potential to provide relatively stable returns with lower risk. Investors seeking some cushioning during market uncertainties may prefer such stocks to balance their portfolio.
• Quality: This focuses on companies with strong financial health. Such companies typically have low debt, stable earnings and good management. High-quality companies have the potential to offer relatively stable growth potential in the long term.
• Size: The size factor often focuses on investing in smaller companies (small cap stocks). Small companies often have higher growth potential than large ones. They can deliver higher returns over time, though they may come with higher risk.

This factor investing style can be used for direct stock market investing as well as mutual funds. These factors are combined in various ways to create strategies that work for investors.

History of factor investing

Factor investing may sound like a new concept, but its roots go back decades.

• In the 1960s, researchers developed the “Capital Asset Pricing Model” (CAPM). It introduced the concept of market factors that affect stock returns.
• By the 1990s, economists Eugene Fama and Kenneth French identified factors like value and size that explain market performance.
• Over time, advanced technology and data analysis made factor investing easier for everyone. Today, factor investing strategies are widely used by professional and retail investors alike.

Why factor investing matters

Factor investing is important because it brings a systematic and disciplined approach to investing. Unlike traditional investing, which often relies on intuition or trends, factor investing is backed by data and research. It avoids guesswork and helps investors understand what drives their portfolio returns.

By focusing on proven factors, investors can make more informed decisions and reduce emotional biases. It also allows investors to customise their portfolios based on their goals, such as seeking higher return potential, lowering risk or increasing portfolio stability.

Many mutual funds today use factor investing strategies to offer strategic investment options, making it easier for everyday investors to benefit from this approach. With its focus on transparency and consistency, factor investing helps build confidence and clarity for investors in an otherwise uncertain market.

Advantages of factor investing

Factor investing comes with several benefits for investors:

• Higher returns
  Factors like value, quality and momentum have been proven to deliver higher returns over time*. These strategies identify specific drivers of performance, allowing investors to focus on what works consistently. *Past performance may or may not be sustained in the future.
• Reduced risk
  Factors like low volatility focus on relatively stable stocks. This can reduce the risk of losses, especially during market downturns, making it suitable for investors who want lower volatility.
• Better decision-making
  Factor investing is based on clear, data-driven research. This removes emotions and guesswork from investing, ensuring a more disciplined and rational approach to decision-making.
• Customisable strategies
  Investors can mix-and-match factors based on their goals, like growth, income or low volatility. Factor-based strategies can be tailored to align with different risk appetites and financial timelines.
• Diversification
  By combining multiple factors, investors can create well-diversified portfolios. This reduces overdependence on a single factor, improving overall risk-adjusted returns.
• Transparency
  Factor investing offers greater transparency as it allows investors to clearly see the rationale behind selecting specific stocks. This builds confidence and trust in the investment process.

Disadvantages of factor investing

As with any investment strategy, factor investing also has some challenges:

• Market changes
  Factors that worked well in the past may not always perform in the future. Changing economic conditions or investor behavior can impact their effectiveness.
• Complexity
  Understanding and using factor investing strategies can be tricky for beginners. Investors may need to spend time learning about factors and how they work.
• Costs
  Some factor investing mutual funds may have higher fees due to the research and analysis involved. These costs can affect overall returns, especially in the long run.
• Short-term risks
  Factors may underperform in the short term, even if they potentially perform well over the long term. There are likely to be phases of underperformance, for which investors must be prepared.
• Requires discipline
  Investors need to remain patient and stick with their strategy during market ups and downs. Abandoning a strategy too soon can lead to missed opportunities.
• Overcrowding risk
  As more investors focus on the same factors, the advantage of certain strategies can decline, reducing their potential for better returns.

The future of factor investing

Factor investing is becoming more popular as technology and data improve. With better access to information, investors can now identify factors that work for them. Advanced tools, such as artificial intelligence and big data analytics, are making it easier to analyse vast amounts of information and implement factor investing strategies effectively.

Mutual funds and ETFs focused on factor investing mutual funds are growing rapidly, offering retail investors smarter and more accessible options. Investors are also combining multiple factors, such as value and low volatility, to create smarter and more balanced portfolios that suit their financial goals.

In the coming years, factor investing in India and across the world is expected to play a significant role in helping investors achieve higher returns and manage risk. As more investors become aware of its benefits and new innovations emerge, factor investing is likely to become a key pillar of modern investment strategies.

Conclusion

Factor investing is a strategic, research-driven way of investing that focuses on what really works in the market. By using key factors like value, momentum and low volatility, investors can aim for higher returns and lower risks. While it may seem complex at first, factor investing strategies are becoming more accessible, thanks to mutual funds and new technologies. If you’re looking to take a smarter approach to investing, factor investing could be a suitable option for you.

FAQs

What is the meaning of factor investing?

Factor investing is a data-backed investment strategy that focuses on specific factors or characteristics like value, momentum and low volatility to choose stocks and enhance return potential.

What are the key factors in factor investing?

The key factors are value, momentum, low volatility, quality and size. Each factor explains a specific reason why some stocks perform better in long term.

What are the benefits of factor investing?

Factor investing offers higher returns in long term, reduced risks, better decision-making and portfolio diversification.

Are there any risks associated with factor investing?

Yes, factor investing may underperform in the short term, and factors may stop working if market conditions change.

How can I implement a factor investing strategy?

You can implement factor directly in the stock market, which will require extensive knowledge. You can also invest through mutual funds or ETFs that focus on specific factors like value, momentum or low volatility, which are professionally managed.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.