All you need to know about how factor or smart-beta investing works

Momentum: The underlying principle in the momentum factor is that when a stock rallies, the trend is likely to persist and buying such companies would deliver strong returns. So recent trends in price movement are expected to continue. One of the prominent indices tracking momentum is the S&P BSE Momentum Index. The index comprises 30 companies taken from the BSE Large & Midcap Index. They are selected based on a risk-adjusted price momentum score – obtained by dividing the 12-month price change by the volatility over this period. There is a Nifty 200 Momentum 30 index as well.

Momentum stocks do well during market rallies, but have sharper drawdowns or corrections when indices fall. In general, a stock’s 6 or 12-month returns are taken as important deciding factors.

This would suit investors with a high-risk appetite.

Low volatility: The low volatility strategy involves buying stocks whose prices do not have wild fluctuations, but have some stability in movements. This strategy seeks to generate excess returns over standard benchmarks by investing in a portfolio of stocks that have low volatility – they do not gyrate much like the broader markets. Low volatility stocks typically have lower risk and beta (correlation with the regular index or benchmark). Volatility is measured by calculating the standard deviation of a stock’s price movement.

They perform extremely well during turbulent or falling markets, as low-volatility stocks correct less than the standard indices. But low-volatility stocks can miss out during strong bull market rallies.

The S&P BSE Low Volatility Index, Nifty 100 Low Volatility 30 and Nifty Alpha Low Volatility 30 are some examples of indices tracking the factor.

Quality: Companies falling under the quality tag tend to have lasting business models and have considerable competitive advantages.

Such quality firms tend to have low debt, substantial cash positions and strong earnings trajectories. They are characterized by low debt-equity ratio (minimal or no leverage), high return on equity (RoE) and return on assets (RoA), as well as superior margins.

Such stocks usually command premium valuation over other firms in the market given their superior financial and return metrics.

There are at least three indices - S&P BSE Quality, NIFTY100 Quality 30 and NIFTY200 Quality 30 – tracking the factor.

These stocks move steadily but strongly over time, and remain stable during bearish markets or macroeconomic conditions.

Value: This is one of the oldest fundamental factors applied to select stocks that trade below their fair value. The idea is to buy stocks that are low on valuation metrics compared to their earnings prospects. Price to book, price to earnings, discounted cash flows and even dividend yield are some of the metrics used to shortlist stocks based on the value factor.

We have the S&P BSE Enhanced Value Index tracking the factor as does the Nifty 50 Value 20 index. These stocks do well in market rallies and are generally cyclical in nature. Such value stocks can also underperform the markets for prolonged periods of time.

Dividend yield: As the name suggests, such stocks are arrived at based on the application of the filter of high dividend yield. That is, these stocks give higher dividends than a standard index or other companies in the same industry. Such stocks work well in rangebound and volatile markets where returns are more likely from dividends rather than capital gains. These are typically large companies with a few midcaps as well.

The S&P Dividend Stability Index captures stocks that have stable or increasing income over at least 7 of the past 9 years.

Nifty Dividend Opportunities 50 is another such index based on the factor.

Smart-beta products and what investors must know

Mutual funds and exchange traded funds (ETFs) tracking various factors are relatively new in India. Most have a track record of less than two years. But the interest in factor investing is increasing.

For each of the factors mentioned above, there are index funds and ETFs from ICICI Prudential, HDFC, UTI, Nippon India, Motilal Oswal and Aditya Birla Sun Life.

The expense ratios are typically low for factor-based index funds and are usually less than 1 per cent even for the regular plan. Over the long term, some of these factor indices have outperformed plain-vanilla indices. Also, there is no fund manager risk while investing in passive funds.

Investors can consider investing small portions in such funds depending on their goals and risk appetites, after consulting their financial advisors.

The mainstay or core of their portfolios should still be normal active equity mutual funds (Flexicap, multi-cap, large, mid and small caps) with some passive schemes in certain cases.

But investors must also be aware of a few aspects before investing in such funds. First, each factor delivers at different point in time in the market and has its own fluctuations. Factors can be cyclical and can play out in a lumpy fashion. Therefore, choosing the factor suitable to your risk appetite is critical.

Investing in factor-based indices will mean exposure to portfolios with lop-sided holdings across sectors and stocks. Exposure can be concentrated in very few stocks and sectors, which can be risky.

Finally, smart-beta or factor investing is based on past data or back-tested data. There is no certainty that a factor will play out the way it did in the past.

*Data as on Apr'23