What is Factor Investing in Mutual Funds?

Factor investing is a rule-based investment approach in which mutual funds select stocks based on specific factors, such as value, momentum, or quality, with returns determined by market conditions.

Factor investing is seeing strong growth in India. The assets under management (AUM) in factor-based funds increased from about ₹7,050 crore to ₹26,363 crore in a single year through July 2024, reflecting rising investor participation. 49 factor-based funds were launched, including 9 new funds introduced in 2024. That indicated growing interest in structured investment approaches.

So, what is factor investing, and how does it work in mutual funds? Let’s understand this in simple terms.

What does Factor Investing in Mutual Funds Mean?

Factor investing is an investment approach where stocks are selected based on specific characteristics, known as “factors,” that may influence returns over time, depending on market conditions.

Instead of picking stocks purely based on a fund manager’s judgement, factor-based investment funds follow predefined rules. These rules identify companies that display certain measurable traits. For example, a fund may select stocks with strong price trends or stable earnings.

A simple factor investing example would be a fund that selects companies with low price-to-earnings ratios under a “value” strategy. The fund portfolio is then constructed based on this rule.

The factor investing in India has grown through factor-based indices and index-linked mutual funds. These funds aim to replicate the performance of a specific factor index, subject to tracking error.

What are the Factors Used in Factor Investing?

There are several commonly used factors in factor investing strategies. Some of the most popular ones include:

1. Value Factor

Value focuses on stocks that seem undervalued based on financial ratios, like price-to-book or price-to-earnings.

2. Momentum Factor

Selects stocks that have shown relatively strong recent performance. The idea is that trends may continue in the short term, depending on market sentiment.

3. Quality Factor

Targets companies with strong balance sheets, stable earnings, and lower debt levels.

4. Low Volatility Factor

Includes stocks that have shown relatively lower price fluctuations compared to the broader market.

5. Size Factor

Invests based on market capitalisation, such as focusing on mid-cap or small-cap stocks.

These are some of the main types of factor investing, though actual fund strategies may combine multiple factors.

What are the Benefits of Factor Investing in Mutual Funds?

Even though the outcomes depend on market conditions, here are several potential benefits of factor investing.

1. Rule-Based Approach

Factor-based funds follow a transparent and systematic process. This reduces reliance on individual stock-picking decisions.

2. Diversification

Since these funds typically invest in a basket of stocks, they provide diversification within the chosen factor theme.

3. Targeted Exposure

Investors can gain exposure to specific market characteristics such as value or momentum.

4. Cost Efficiency

Many factor-based funds are structured like index funds, which may have relatively lower expense ratios compared to actively managed funds.

However, it is important to understand that no single factor performs well at all times. Performance may vary depending on economic cycles and market volatility.

How to Invest in Factor-Based Mutual Funds?

You can invest in factor-based mutual funds just like any other mutual fund investment.

1. Lump Sum Investment

Invest a one-time amount based on your financial goals and risk tolerance.

2. Systematic Investment Plan (SIP)

You may invest regularly through a SIP. A SIP helps bring discipline to investing and may reduce the impact of short-term volatility, depending on market conditions.

Using a SIP calculator can help estimate possible investment outcomes over time. However, these are projections based on assumed rates of return, and actual returns may vary.

Before investing, consider:

• Your investment horizon
• Your risk appetite
• The specific factor strategy used
• Portfolio concentration

Since factor investing strategies are market-linked, returns are not guaranteed and depend on overall market performance.

Making Factor Investing Part of Your Portfolio Strategy

Factor investing can be considered as a way to diversify your investment funds beyond traditional active or passive strategies. Instead of relying solely on broad market exposure, investors can choose funds aligned with specific factors such as value, quality, or momentum.

However, factors may go through periods of underperformance depending on market trends. For example, momentum strategies may perform differently in trending markets compared to sideways markets. Therefore, factor-based funds are generally more suitable for investors who understand market cycles and are willing to stay invested over a suitable time horizon.

Before investing, it may be helpful to review scheme documents carefully and, if required, consult a financial advisor to ensure the investment aligns with your financial goals.

FAQs

1. What's the difference between factor investing and smart beta?

Smart beta is a broader term used for rule-based investment strategies that go beyond traditional market-cap weighting. Factor investing is a smart beta strategy that focuses on measurable factors such as value and momentum.

2. What are some of the myths associated with factor-based investing?

One common myth is that factors always outperform the market. In reality, factor performance depends on market cycles and economic conditions. No factor guarantees consistent returns.

3. Are factor-based funds suitable for all types of investors?

Factor-based funds may not suit everyone. Investors should consider their risk tolerance, time horizon, and financial goals before investing, as returns can fluctuate depending on market conditions.

4. How do factor-based funds differ from traditional mutual funds or ETFs?

Traditional actively managed funds rely on fund manager decisions. Factor-based funds follow predefined rules. Some factor funds are structured as index funds or ETFs that track a factor index.

5. How does market volatility affect factor-based funds?

Market volatility can impact factor performance. Some factors, like low volatility, may perform differently during turbulent periods, while others, like momentum, may react strongly to trend reversals, depending on market conditions.

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