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Tata Capital > Blog > Wealth Services > What is Factor Investing, Types, and Building a Portfolio Based on Market Factors

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What is Factor Investing, Types, and Building a Portfolio Based on Market Factors

What is Factor Investing, Types, and Building a Portfolio Based on Market Factors

Mutual funds offer convenience by allowing investors to avoid selecting individual stocks or assets; instead, they invest in a pre-selected, well-performing mutual fund. However, there are costs associated with mutual funds, such as the expense ratio and other fees.

But what if you could easily select investments based on your risk and return preferences to maximise wealth? This is where factor investing comes into play. Each asset has certain attributes or characteristics that can drive higher returns over time. These characteristics can help shape your portfolio to manage returns across different market cycles.

This article explores factor investing, its types, and the pros and cons of this approach.

What is Factor Investing?

Factor investing is an investment strategy that targets specific drivers of returns across asset classes. By focusing on these drivers or factors, investors aim to get higher returns, increase diversification, and manage risks in a portfolio.

Types of Factor Investing

Factor investing involves two main types: macroeconomic factors and style factors.

Macroeconomic factors

These factors represent broad economic trends that can influence market performance.

They include:

  1. Interest rates – Higher interest rates discourage businesses and individuals from borrowing, such as taking out loans. They also reduce purchasing power and slow down economic activity.
  2. Inflation – Inflation reduces purchasing power as goods for the consumers as they become more expensive. Higher inflation reduces real return of investments as well. Since income and investment growth often falls short of inflation, it negatively impacts consumer spending and thereby businesses and stock prices.
  3. Economic growth – The country’s overall economic growth improves consumer spending thereby improving corporate earnings and, consequently, stock prices. On the other hand, declining economic growth leads to decline in stock market performance.
  4. Credit – Credit risk is the risk investors take when investing in companies with lower credit rating for higher returns. Higher credit risk denotes higher probability of default in repayment of loan by the borrower. Investors earn higher returns for this risk, but since companies have varying default risks, careful assessment is essential before investing.

2. Style factors

Style factors are characteristics specific to individual securities or assets.

They include:

  1. Value – This involves picking undervalued stocks through fundamental analysis, using metrics like the price-to-earnings ratio, price-to-book ratio, price-to-sales ratio, and dividend yield.
  2. Size – Size of the company is one of the styles in factor investing. Small-cap companies, which are smaller in market value and have the potential to offer better returns than large-cap stocks.
  3. Momentum – This style targets stocks with strong recent performance, assuming they will continue to perform well in the near future. Momentum is typically measured over a short term, such as three months to a year.
  4. Quality – Quality factors focus on financially healthy companies with high returns on equity and assets, low debt-to-equity ratios, and strong management.
  5. Dividend yield – This factor identifies stocks with high and growing dividend yields, which often outperform those with lower yields.
  6. Volatility – This factor involves selecting stocks with lower volatility. Low-volatility stocks tend to provide more stable returns and can be particularly appealing during market downturns.

Pros and Cons of Factor Investing

Here are the pros and cons of factor investing.

Pros

  • Better returns: Identifying and investing in specific factors can help investors outperform the market. For example, value and momentum factors have historically provided higher returns than the broader market.
  • Risk management: Factor investing diversifies across different factors, reducing overall portfolio risk. Balancing factors like value, momentum, and quality can mitigate risks associated with individual characteristics.
  • Systematic approach: This strategy uses a rules-based approach, minimising emotional biases that can impact investment decisions, leading to more disciplined and consistent practices.

Cons

  • – Complexity: Factor investing can be complex, requiring a deep understanding of various factors and their interactions, which can be challenging for individual investors without the necessary expertise or resources.
  • – Market cycles: Factors can go in and out of favour depending on market conditions. For instance, value stocks may underperform during growth-driven bull markets, while momentum stocks may struggle during market corrections.

Conclusion

Factor investing is a disciplined strategy that selects investments based on specific characteristics. It helps reduce emotional decision-making, manage risk, and achieve better returns. For expert guidance in making informed investment decisions, consider Tata Capital Wealth. We offer meticulously researched and personalised financial products tailored to meet your financial goals. Visit our website today!

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