Factor investment is one of the many strategies that experts use while investing. It combines active and passive investing to capture extra returns at reduced risk. This investing concept is relatively new in India. If you want to learn more about factor investing, keep reading.
Factor investing is gaining momentum in India. Many investors want to know more about the new investing style to help them better manage their portfolios.
What is Factor Investing?
As the name suggests, factor investing means selecting investments based on factors that can help generate higher returns, improve diversification, and manage overall risk better.
Investors use two broad categories of factors in the factor investing style.
Macroeconomic factors: It includes the general risks affecting asset classes like economic growth, inflation rate, emerging market, actual rates, liquidity, and such.
Style factors: These are risk factors specific to the asset class, such as volatility, momentum and value. Primary style-based factors are value, minimum volatility, momentum, quality, size etc.
Factor investing is not a new concept, but it has gained momentum with investors recently. It involves targeting specific drivers of returns across asset classes.
Types of Factors
Understand how the factors work better to capture the potential of excess returns at reduced risks.
Investors considering the value factor invest in stocks trading at a lower price than their fundamental value. Investing in such stocks can earn higher returns when the stock price increases or adjusts to the market level. Several ratios can help you identify undervalued stocks.
- Price to earning ratio (P/E)
- Price to book (P/B) ratio
- Price to sales (P/S) ratio
- Price earnings growth rate ratio
- Debt to equity ratio
- Debt to asset
- Dividend payout ratio
Many mutual funds invest following factor-based investing strategies. You can invest in these mutual funds if you plan to start factor investing.
Investors use company size as a factor while investing. It helps investors select small-cap companies as these are supposed to generate higher capital returns than large-cap businesses.
Quality of the company
A company’s quality is linked to its fundamentals like corporate governance, debt position, consistency in performance etc. Fundamentally strong companies tend to outperform their peers eventually.
Some investors consider momentum a critical factor for investing. It helps investors identify stocks that have showcased strong growth in the past.
Volatility is a measure of the price change of stock. Some investors think that low-volatility stocks generate better risk-adjusted returns. So they would select stocks based on the volatility factor.
Using dividend yield as an investing factor will help you identify stocks that pay a higher dividend to investors. Many investors would make investment decisions on dividend yield considering these stocks will outperform peers in the long run.
Benefits of factor-based investing
Adopting a factor investing method has several benefits.
Combines active and passive investing
Investors and asset managers use active and passive investing strategies to move their investments for better returns.
Active investing refers to actively choosing the stocks in the mutual fund based on your research and analysis. In passive investing, investors invest in index funds with the exact composition of a benchmark index.
Active investment costs more than passive investment. Factor investing charges more than passive investment but less than active investment, making it an excellent choice to gain extra returns at a reduced cost.
In factor investing, the investment decisions are made based on evidence or performance metrics, making factor investing a more reliable strategy.
Since the investment decisions are made based on various factors that let you filter through stocks based on your investment objectives, it allows higher diversification.
Once you understand factor investment’s meaning, it’s time to plunge. Only make sure the factors you select aren’t correlated. If you are ready to invest, open a demat account with Angel One now!