The first approach, called factor-based investing, uses a data-backed strategy to deliver a well-diversified portfolio that offers better returns with lower risk. This method adopts a rule-based quantitative methodology to assign weights to a defined set of factors while selecting stocks.
How Factor-Based Investing Works
Factor-based investing evaluates stocks based on certain characteristics that are driving its performance. These factors include:
- Value: Assessing stocks based on metrics like price-to-earnings or price-to-book ratios to uncover undervalued opportunities.
- Momentum: Identifying stocks with strong recent price performance, indicating potential for continued upward movement.
- Size: Focusing on smaller companies known to outperform larger peers over the long term.
- Quality: Targeting companies with robust financial health, high profitability, and stable earnings.
- Volatility: Investing in stocks with lower price variability.
Once identified, these factors are used to construct portfolios that tilt towards desired attributes while maintaining diversification. A multifactor approach helps combine different factors to reduce the risk of relying on a single factor and deliver relatively higher risk-adjusted return as underperformance of one factor may be offset by the outperformance of another.
Advantages Over Traditional Methods
Factor-based investing offers several advantages compared to traditional strategies:
- Disciplined process: uses a rule-based investment strategy which reduces the human biases making it more reliable and transparent process
- Reduced Risk: diversification across multiple factors can help smoothen our portfolio volatility. This also adds on the additional element of investment style diversification to a portfolio
- Improved Returns: with reduced risk, the portfolio is able to deliver better risk-adjusted returns
- Tailored Solution: focusing on specific factors, can help cater to investors with different risk appetites and investment goals.
Expertise in Factor-Based Investing
Successful factor-based investing requires expertise in data interpretation, trend analysis, and portfolio rebalancing. This ensures portfolios remain adaptive to evolving market conditions, optimizing risk-adjusted returns over time. Factor-based strategies offer a systematic and transparent approach to achieving superior investment outcomes.
One specific application of factor-based investing is to identify trends in business cycles.
Business Cycle Fund: Steering Your Investments Like a Team Captain
Imagine your investment journey as a world cup match where cricket team strategies and player selection depend on individual strengths, current form, and the opponent team. Just as a cricket team adapts its lineup and tactics for different pitches and opponents, an investment portfolio must adapt to evolving market conditions.
The Business Cycle Fund operates with a captain’s mindset, akin to a cricket team captain adjusting the game plan based on match conditions. Like a captain analyzing the pitch, weather, and opponent’s strengths and weaknesses to devise the best strategy, the Business Cycle Fund adjusts its investment approach based on the prevailing market environment. There are over 160 sector/thematic schemes in the Indian mutual fund industry. With an AUM of over Rs. 25,000 crores, Business Cycle Funds are the fifth largest in the thematic/sectoral category.
Sector-based funds can be cyclical, exposing investors to volatility in returns. Business Cycle Funds offer a diversified investing approach, strategically rotating across sectors in different market environments. Such a fund provides investors with a convenient and unique solution by implementing dynamic sector rotations. This strategy effectively addresses the common challenge of timing sector entries and exits, which investors often struggle with. Momentum has been the best-performing factor in India for many years, and when combined with other fundamental factors, it proves highly effective in generating long-term alpha.
Investing in a business cycle fund makes sense in a volatile market as it provides a diversified and adaptive strategy to navigate different market conditions.
(Niranjan Avasthi, SVP & Head – Product, Marketing & Digital Business at Edelweiss Mutual Fund)
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)
