Ahmedabad, Passive Growth Story, India’s passive growth story has been steadily increasing with significant growth over the past few years. At an AUM size of ₹6.04 lakh crore, this accounts for 15 percent of the ₹39 lakh crore story1. As the industry continues to grow, we are seeing asset managers diversify their product offerings and try alternative investment strategies such as factor investing. A Passive Approach to Factor Investing in India
Investing in factors is significant globally and as of March 31, 2022, factor ETFs managed approximately $1.6 trillion in assets globally, a growth at a CAGR of 24.6 percent from $178 billion 10 years ago. 2
What is Factor Investing?
Factor investing in general is concerned with an approach, with the characteristics of a target stock leading to a difference in expected returns over the long term.
Factor investing is sometimes related to smart beta or strategic beta, as the factor approach systematically separates the underlying portfolio from the market portfolio (market beta).
Some general factors well documented in the academic literature and accepted by the investment industry include low volatility, volatility, quality and value.
While active fund managers and institutional investors often use a factor-based approach to strategically construct portfolios or adjust their portfolios to factor risk premiums, factor-based investing can be implemented with the help of factor indices, which aim to assign investment opportunities to specific factors. , which follows rules-based methods, which are more cost-effective and transparent than actively managed portfolios.3
How Factor Indicators Work
Factor indices are not designed to replace market-cap-weighted indices. While broad-based or market-cap-weighted indices represent a complete investable opportunity for market participants, factor indices seek to leverage targeted risk following a rule-based and transparent index methodology.
Stock selection for these indices is based on specific factor criteria along with stock weights, which are related to the stock’s factor score, which is used to create factor tilt within the index portfolio.
Unlike passive products based on broad-based indices, factor-based strategies can provide market participants with an opportunity to express their active opinions separate from market-cap-based portfolios. Hence, factor performance should be evaluated against a market-capitalization-weighted benchmark over the long term, as with active funds.4
If we look at how S&P BSE Factor Indices have performed in the domestic market, some of our findings show that S&P BSE Law Volatility, S&P BSE Momentum and S&P BSE Quality Factors have performed well in the Indian market for 17 years since 2015. If so, the value factor has relatively underperformed the market. The S&P BSE Value Factor Index was negatively correlated with the other three factors.
What is Multi Factor Strategy?
While single-factor smart beta strategies tend to outperform the market over the long term, they tend to experience periods of lower returns under various extended economic conditions, depending on their cyclical characteristics.
A mix of factors in a portfolio for diversifying factor investments can help achieve higher returns easily across business and market cycles, based on the effective dependence of return correlations across factors.
A multi-factor strategy combining the four S&P BSE factors can be an alternative to traditional equity allocation. Over the past period (17 years since 2015), the multi-factor strategy has returned more than 2 percent per year, including 5 percent tracking errors, and has delivered higher returns in various market conditions.
Conclusion- The growing popularity and appeal of factor-based indices has led to innovation in the multi-factor investing space. In addition to widening the range of multi-factor indices in more areas, combinations of different factors can also be applied.