Things you need to know about factor Investing

The global pandemic necessitated the need amongst people to earn extra income. As working from home became the norm, people realised that they need more money and the income earned from full-time employment may not be enough. That’s where investing stepped in for some. Some of them saved a part of their income to invest in the market. By doing so, they were able to create wealth for future expenses.

Investing is the act of allocating funds into investment tools with the objective. However, there are two things you need to remember about investment planning. Firstly, you need to be prepared to take risks if you are considering investing as a probable source of extra income. Secondly, they are not a monolith and there are numerous types of investing, one of them being factor investing.

What is factor investing?

Factor Investing, also referred to as smart beta investing, is a subset of quant investing where the fund manager seeks to identify securities based on patterns or features common to all those securities that help deliver the overall portfolio returns. It is an investment strategy which is known for combining active with passive styles of investing to capture excess returns at reduced risk.

Funds following the factor investing approach are constructed to target specific stocks that exhibit a characteristic that drives returns. While relatively new, this strategy is gaining ground for investment in mutual funds. In this strategy, fund managers use five factors, namely, value, growth, quality, momentum and volatility — to build indices to generate smart beta or alpha strategies.

Types of factors:

Listed below are the five factors that fund managers use in this strategy:

Value:

The fund manager uses this approach to screen under-valued stocks that are in the market in terms of price-to-earnings and price-to-book ratios.

Growth:

This approach is used to check the alpha, (i.e., a` measurement of performance) of stocks of companies. It is determined from earnings as well as revenues.

Quality:

This approach is used to check the quality score of the stock. It is determined using the return on equity, debt to equity and earnings per share growth. The momentum-based approach focuses on the opportunities that will generate strong returns, against past returns.

Volatility:

Through this approach, the fund manager determines the level of volatility of stock using standard deviation to ensure returns are not affected.

Are there any benefits of factor investing?

Listed below are some of the benefits of factor investing:

• They provide a broad exposure to investors:

Factor investors allow investors to invest in a basket of stocks depending on their risk appetite and preferred investment style. Factor-based strategies provide exposure to multiple factors within one vehicle, giving investors a better shot at achieving risk-adjusted returns.

• They have lower expense ratios:

While it is true that the expense ratios of these funds are higher than those of passive funds, they are much lower than those of actively managed funds. Some of these funds have an expense ratio as low as 0.14%. This is one of the alluring features of factor investing.

• Investments can be diversified easily:

Factor-based models are known for representing a broad universe, which enables diversification. Besides the advances in technology and data analysis, more enhanced tools and processes are being used to construct more factor-based mutual fund portfolios. This gives an advantage to investors to choose multiple funds.

• They are also very transparent:

Another major merit of this approach is its objectivity and evidence-based nature. While the traditional investment approach (active management) can tend to be somewhat of a black box, factor Investing is a more transparent & easier to understand approach.

If you are looking for a mutual funds investment option that offers benefits such as reducing the overall portfolio risk and a low expense ratio, look no further than factor Investing.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.