“Factors” and Factor Investing are getting increasingly popular in the Indian market. A “Factor” is a differentiating characteristic of a stock that delivers excess returns. These factors are deep-rooted rationales for outperformance that have lasted over decades. While “factor investing” usually requires a lot of data and numbers, factors are very intuitive to understand for a regular investor. 

Factor investing strategies are typically created as a basket of stocks. However, as quantitative methods are used in making these strategies, the baskets are very well diversified and, more often than not, carry a risk less than the Nifty index! These factors may include characteristics such as value, momentum, quality, size, and volatility. By focusing on these factors, investors can potentially capture returns not explained by traditional market indices, such as the Nifty 50.

One way that factor investing leads to alpha returns is through portfolio diversification. By investing in various factors, investors can potentially reduce the risk and volatility of their portfolio compared to traditional index-based investments. This can lead to higher returns over the long-term, as the portfolio can better weather market downturns and capture returns from various sources. Another way that factor investing leads to alpha returns is through the identification of mispriced assets. By focusing on specific characteristics, investors can potentially identify undervalued assets that the market may overlook. This can lead to higher returns as the assets appreciate in value over time.

Overall, factor investing can lead to alpha returns by providing diversification and the potential to capture returns from mispriced assets. This can result in higher returns compared to traditional index-based investments, which may not consider these factors.

Some common factors in factor investing include:

1. Value: This factor refers to an asset’s relative cheapness or expensiveness based on its price-to-earnings ratio, price-to-book ratio, or other financial metrics.
2. Momentum: This factor refers to an asset’s price tendency to continue moving in the same direction as it has been trending.
3. Quality: This factor refers to the financial strength and stability of a company, as measured by metrics such as its return on equity, earnings stability, and debt-to-equity ratio.
4. Size: This factor refers to the market capitalization of a company, with small-cap stocks generally considered to be riskier but with higher potential returns than large-cap stocks.
5. Volatility: This factor refers to the level of risk associated with an asset, with more volatile assets generally considered riskier but with higher potential returns.

Factors that may be considered in factor investing include yield, low correlation, and sustainability.

The performance depends on the portfolio creator, but simple tools like diversification, risk targeting, and dynamic deallocation can make these strategies extremely safe. While some factors like momentum are excellent ways to take advantage of the bull market, a multi-factor approach can be a perfect way to compound your way to outperformance at a risk which is much better than the market.