What is Factor Investing? Benefits, Applications, and Key Advantages

Do you seek to build an investment portfolio comprising stocks and mutual funds that have performed well in the past or have low volatility? Do you focus on attributes such as quality, value and size while investing money in different asset classes? If the answer to the above questions is a resounding yes, you are a proponent of factor investing.

What is Factor Investing?

Factor investing is an investment strategy that involves choosing financial instruments like stocks, mutual funds, bonds, etc., based on certain attributes. These attributes can be categorised into two broad categories:

• Macro Factors

These involve broad economic factors impacting the entire market, such as inflation, interest rates and economic growth, among others.

• Style Factors

Style factors include specific characteristics that could impact the performance of an asset class. These include volatility, momentum, quality and size, among others. Combining these factors can help you create an investment portfolio that aligns with your goals.

Advantages of Factor Investing Strategy

Factor investing strategy has numerous advantages. Some prominent ones are:

• Higher Return Potential

As factor investing aims to bank on factors that have historically driven returns or which have outperformed the market. A systematic application of the factors while investing money can position your portfolio to adapt to diverse conditions and market environments. This can subsequently drive growth in the long term.

• Helps in Risk Management

A robust investment strategy offers the guard rails against risk. You can mitigate risks by targeting factors performing well in diverse conditions. For instance, less volatile stocks and mutual funds can perform better during market downturns. This provides a cushion against losses and can help stabilise your investment portfolio when markets experience heightened volatility.

• Offers Transparency

A factor investment strategy is rule-based. It means it follows a set of criteria. This gives you a holistic understanding of the rationale behind investment decisions, thus making it easier for you to monitor and manage your portfolio.

• Aids in Diversification

Investing money in different asset classes across factors, which aren’t correlated with each other can help you diversify your investment. This reduces the chances of underperformance in any single factor, thus providing stability to your portfolio.

Application of Factor Investing

Suppose you are interested in investing in stocks based on momentum and size. While momentum refers to stocks that have performed well in the past and are likely to do well in the future, size refers to a company's market cap. Based on these two factors, you pick up a mid-cap or a small-cap stock that has shown steady growth in the past.

However, as mid-cap and small-cap tend to be risky, you add a quality large-cap stock with a history of stable returns. Combining these factors can help you create a robust, resilient, growth-oriented investment portfolio. In India, factor funds are available in index funds and exchange-traded funds (ETFs).

Conclusion

While factor investing can help you bank on specific factors driving returns and presents you with opportunities for enhanced returns and risk management, it's crucial for you to be aware of the associated risks. Note that market condition changes can impact a factor strategy's effectiveness. A careful selection can help you achieve your goals more effectively.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.