Factor Investing in Mutual Funds: Meaning, Benefits & More

Factor-based funds are created and managed by focusing on key factors that have historically been linked to better long-term performance. These factors include:

Value

This factor targets undervalued stocks, often identified by low price-to-earnings (P/E) or price-to-book (P/B) ratios. Investors believe that these stocks are priced lower than their intrinsic value, offering the potential for price appreciation over time.

Momentum

This factor invests in stocks with strong recent performance, operating on the belief that stocks that have done well in the past will continue to perform well in the short term.

Quality

Quality factors focus on companies with strong financial health, such as high profitability, low debt, and consistent earnings. These companies are often seen as more resilient during market downturns.

Volatility

Low volatility strategies invest in stocks with consistent price movements, seeking to reduce risk in the portfolio. These stocks tend to be less volatile, appealing to more conservative investors.

Size

The size factor focuses on the market capitalization of companies, often favoring small-cap or mid-cap stocks, which have historically offered higher growth potential compared to large-cap stocks.

Single Factor Funds

These funds focus on a single investment factor to achieve desired outcomes. Examples include:

Value Factor Funds

These funds aim to invest in undervalued stocks with strong fundamentals. They focus on stocks trading at lower prices relative to earnings, book value, or dividends.

Momentum Factor Funds

These funds invest in stocks showing consistent growth over time. Bandhan offers funds like the Bandhan Nifty 500 Momentum 50 Index Fund and the Bandhan Nifty 200 Momentum 30 Index Fund, which track high-performing stocks based on momentum.

Quality Factor Funds

Focus on companies with strong financial health, low debt, and solid earnings growth. These funds target businesses that have a history of generating consistent profits.

Multi-Factor Funds

These funds combine two or more factors to provide a diversified investment approach, minimizing the risk of relying on one factor. For example:

Value + Quality Funds

These funds invest in undervalued companies with strong financials.

Momentum + Low Volatility Funds 

These funds combine momentum strategies with a focus on minimizing risks by investing in less volatile stocks.

Smart Beta Funds

These funds use alternative index construction strategies that are not purely market-capitalization-weighted. For example:

Equal-Weighted Smart Beta Funds

These funds allocate equal weight to all stocks within the index, rather than market capitalization. This helps avoid overconcentration in large companies and provides balanced exposure.

Factor-based funds offer different investment strategies depending on the risk and return objectives, giving investors flexibility in constructing their portfolios.

Now that we have seen the types of factor-based mutual funds, let us also explore some of their advantages including diversification, risk management, and risk-adjusted returns.

Diversification

Factor funds provide a way to diversify beyond traditional market indices. By focusing on specific factors like value, quality, or momentum, these funds reduce exposure to any single risk factor, allowing for a more balanced portfolio. This diversification can help smooth out volatility and potentially improve overall portfolio performance.

Risk Management

Factor funds offer built-in risk management by targeting stocks with certain characteristics that align with an investor’s risk tolerance. For example, low-volatility funds focus on consistent, less risky stocks, while quality-factor funds target financially sound companies. By selecting funds based on these factors, investors can tailor their portfolios to minimize risks while still aiming for growth.

Risk-Adjusted Returns

One of the key benefits of factor funds is the potential to achieve superior risk-adjusted returns. By selecting factors that have historically delivered higher returns, such as momentum or value, investors can enhance the performance of their portfolios relative to the amount of risk taken. This strategy allows investors to pursue better returns without necessarily increasing their exposure to market risk.

Despite offering several benefits, factor funds come with their own set of drawbacks, some of which are discussed below:

Vulnerability to Market Cycles

Factor funds can be vulnerable to shifts in market conditions. Certain factors, such as value or momentum, may perform well during specific market cycles but struggle during others. For instance, value stocks might underperform during periods of growth, while momentum stocks may not do well in a stagnant market. This makes factor funds subject to market cycles, and they may not always deliver consistent returns.

Factor Underperformance Risk

Each factor, whether it’s value, quality, or momentum, may experience periods of underperformance. There are times when a specific factor might not align with the broader market conditions, leading to lower-than-expected returns. Investors in factor-based funds must be prepared for periods where their chosen factors may not perform as anticipated.

Complex Nature

Factor investing can be more complex than traditional index investing. It involves understanding the various factors, how they work, and how they interact with one another. Constructing and managing a factor-based portfolio may require more time and effort to track the performance and rebalance the portfolio, which could be overwhelming for some investors.

Expense Ratio

Factor funds often come with higher expense ratios compared with traditional index funds. This is because they require more active management, research, and analysis to identify and select the right stocks based on chosen factors. The additional costs can eat into the overall returns, making factor funds less appealing for cost-conscious investors.

Investors planning to invest in factor funds should consider the following factors:

Risk Appetite

Factor funds can be a good choice for investors with a higher risk tolerance, especially those who are comfortable with the potential volatility associated with factors like momentum or value. However, if you prefer a more conservative approach, you may opt for low-volatility or quality factor funds, which focus on consistency and lower risk.

Investment Horizon

These funds can be better suited for long-term investors who are willing to weather short-term fluctuations in pursuit of potential higher returns. Investors with a longer horizon can benefit from the compounding effect of carefully chosen factors that tend to deliver value over time. For those with a shorter-term focus, factor funds might introduce more uncertainty and volatility.

Investment Goals

If your goal is to outperform the market or target specific characteristics such as growth, consistency, or undervaluation, factor funds can offer a customized investment solution. These funds are suited for those seeking specific outcomes, like capital appreciation through momentum or consistent returns through quality and low volatility stocks.

Investing in factor-based funds involves a thoughtful and strategic approach. Here’s a simple step-by-step guide to help you get started:

Research: Start by understanding the various factors such as value, momentum, quality, and volatility. Each factor focuses on different characteristics of stocks, so it’s important to align your investment with the factors that suit your risk tolerance and financial goals. Do thorough research to understand how these factors perform in different market conditions.

Choose a Fund: After identifying the factors you wish to target, select a factor-based fund that matches your investment strategy. Evaluate the fund’s objectives, its past performance, and the costs associated with it. Look at the portfolio composition to ensure it aligns with the factor you’re investing in.

Monitor Performance: After investing, it’s also important to monitor the performance of your factor-based fund. Keep track of how the fund is performing relative to its benchmarks and your financial objectives. Factor-based funds may underperform or outperform the market based on market cycles, so regular review is important.

Stay Informed: Stay updated on market trends, factor performance, and any changes in the fund’s strategy. Read reports and analysis on factor investing and adapt your investment decisions as necessary. This will help you stay aligned with your long-term financial goals.

By following the aforementioned steps, you can make effective decisions when investing in factor-based funds, ensuring your investments are well-suited to your financial objectives.

• Factor investing selects stocks based on characteristics like value, momentum, quality, low volatility, and size, aimed at enhancing returns.
• Factor-based investing includes different types of funds, such as single-factor funds (focused on one characteristic) and multi-factor funds (combining factors for diversified exposure).
• Smart beta funds are a form of factor-based funds that use alternative indexing strategies.
• Factor-based mutual funds offer benefits like diversification, improved risk management, and the potential for higher risk-adjusted returns through a focus on specific investment factors.
• While these funds have potential, they can underperform in certain market cycles and may have higher expense ratios than traditional index funds.
• Factor-investing mutual funds are generally better for investors with a higher risk tolerance, long-term goals, and specific objectives like outperforming the market.
• The process involves researching factors, selecting the right factor-based fund, opening an account, and consistently monitoring performance.