What is factor investing? All you need to know

While you may have heard of diversification as a tried and tested way of mitigating portfolio risk, are you aware of the different ways in which you can diversify your portfolio? Some common methods include investing in various asset classes, market capitalisations, geographies, and industries. However, there is another way to implement diversification and lower your portfolio’s risk. This is known as factor investing. Let’s find out how you can use factor investing when building an equity portfolio.

Understanding factor diversification

Factor investing is a method used to invest in diversified portfolio. It can be broken down into two main categories - macro factors, which affect returns across multiple asset classes, and style factors, which focus on returns within a specific asset class, like equities.

Macro factors can include inflation, liquidity, economic growth, unemployment rate, etc. On the other hand, style factors in equity investing include momentum, low volatility, quality, value, and size. In this article, we will focus on the style factors and how they can help you create a suitable equity portfolio.

Common factors used in equity investing

Here are some different factors used in equity investing:

1. Value: Value stocks are from companies that are presently underpriced but expected to offer long-term value to investors. Value stocks tend to underperform during bear markets as these companies may struggle in economic downturns.
2. Size: The size factor refers to stocks from small-cap companies. These companies are relatively new and small, which is why they have the potential to offer growth as they excel and expand over time. However, they may also underperform during bear markets as small-cap businesses may not be able to withstand severe economic downturns.
3. Quality: The quality factor refers to the quality of the company to which the stock belongs. These typically include well-established and reputed companies that deliver stable returns over different market conditions. Since these companies are widely recognised and have a proven track record, they can provide stable returns even in bear markets.
4. Low volatility: As the name suggests, low-volatility stocks also shine in bear markets as they are more stable. These stocks usually provide a buffer when markets are turbulent.
5. Momentum: This factor performs best in trending markets, whether they are going up or down, but it is vulnerable when trends suddenly reverse.

Benefits of using factor-based diversification

Factor-based diversification can help you build a robust equity portfolio. Just as you diversify across different asset classes, geographies, and industries to protect your money against market swings, you can do the same by diversifying on the basis of different investment factors.

Each factor responds uniquely to different economic cycles. This ensures that when you combine them together, you can spread risk across the portfolio. For instance, while value and size factors might struggle in a bear market, quality and low volatility can provide stability. Including stocks that reflect all of these factors can not only broaden your exposure to different opportunities but also lower risk.

Potential risks of using factor-based diversification

While effective, factor-based strategies can be hard to understand. Understanding how each factor responds to market changes requires a deep knowledge of these market forces. New and younger investors might find this overwhelming, making it harder to keep up. Additionally, rebalancing a portfolio based on factors can also be tricky, as each factor may need individual monitoring and adjustment.

Thankfully, many fund houses offer mutual funds and Exchange-traded Funds (ETFs) that focus on specific factors such as momentum or value. These professionally managed funds allow investors to explore factor-based investing without actively managing the portfolio.

Conclusion        

Factor investing can add an extra layer of protection to your equity portfolio by diversifying risk across different market conditions. However, it is not always easy to implement, especially for those just starting out. Hence, mutual funds or ETFs become a convenient option for exploring the benefits of factor investing.

An investor education initiative by Edelweiss Mutual Fund

All Mutual Fund Investors have to go through a one-time KYC process. Investors should deal only with Registered Mutual Fund (RMF). For more info on KYC, RMF and procedure to lodge/redress any complaints, visit - https://www.edelweissmf.com/kyc-norms  

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS. READ ALL SCHEME RELATED DOCUMENTS CAREFULLY