Factor Investing

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Table of Contents

• Fundamentals of our investing approach
• Quest for superior risk-adjusted returns
• Factor investing - definition, origin, and performance
• Recommendation

A) Fundamentals of Our Investing Approach

1.Why Do We Invest, After All?

We keep reminding ourselves, and our clients, that the exclusive objective of investing is to generate meaningful returns on our savings so that we can live the life we wish to. And thereby, reduce the probability of not achieving their financial goals.

Paradoxically, a poorly made and, or executed, investment plan can increase the probability.

Even more so when we are writing a recommendation note on an investment strategy. Any such note will build a case for the strategy and why it might generate better returns than existing products or strategies.

We also greatly worry how sections of the media and investment industry focus purely on returns with disregard to the risk those returns come with. This has led to a quest of being in the top schemes or funds, ranked purely based on returns. And that too using what is known as time-window analysis, an overly simplistic and misleading approach.

Where returns are computed between two fixed dates. One is the present date, and the other being 6 months, 1 year, 3 years, 5 years, or 10 years back. This analysis gives no idea of the journey and hides a lot more than what it reveals. It is part of investing folklore that investors, on an average, lost money in Peter Lynch's Magellan fund. A fund he managed between 1977 and 1990 and which generated close to 28% per annum return, consistently doing more than double of the S&P Index.

2.Asset Allocation Decisions Contribute to 93% of Return Variability

As per a landmark study done by Brinson, Hood and Beebower in 1986.

How much to invest is more important than where to invest. In other words, what mattered at the bottom of the market in 2002 and 2003 was not which scheme, but how much equity investments, as a percent of portfolio, you owned.

Therefore, right-sizing equity allocation is the key.

3.Stick with a Few Fund Managers or Schemes and Hold Them for Longer Periods

We prefer a buy and hold strategy, over a churn strategy, as we believe compounding works better than timing.

Our experience working with several wealth managers shows that there is very little to show in terms of a demonstrable track record, after accounting for tax and transaction costs, where they have consistently captured the winning strategies.

B) Superior Risk-Adjusted Returns

1.As Far as Possible, We Compute Daily Rolling Returns

For some products and schemes, like PMSs, daily data is not always available.

Daily rolling returns analysis is where we take a start date, say 10 years back. The further back, the better. And then assume that an investor invested every day for a period of 1 year, 3 years, 5 years, and so on. This way, we capture different entry and exit points of the strategy and not rely on just one set of entry and exit points, which time-window analysis does.

What we get is a large number, running into a few thousand, of observations for every time-period. An average or a median return of those observations, we believe is a better indicator of the likely return. This approach also gives us a minimum and maximum return figure, which further gives the investor an idea of the range of outcomes.

We can then compute the standard deviation of these daily rolling returns which is a universally accepted measure of volatility, and then arrive at the Sharpe Ratio.

Just FYI - we are also in the process of building both an asset allocation and a scheme selection framework using Modern Portfolio Theory, propounded by Nobel prize-winning American economist Harry Markowitz. This theory uses concepts such as correlation, risk, and return to find the optimal portfolio weightings.

2.The Long and Short of It

When looked at from the lens of risk-adjusted returns, hedge funds, long-short and absolute return, do well. Recently, one such scheme was awarded as the best Indian Equity fund in an international award event. The basis was the Sharpe Ratio, and on that count this scheme scored well. On a pure return basis, it has been generating about 10% on a post-tax basis.

However, many investors argue that they will keep a certain amount of funds aside in high-quality bonds, which will serve as their safety nest. And the rest they rather invest in equity, with the expectation that over longer periods, equity will generate superior returns.

This is one reason why hedge funds get limited allocations, as neither do they give the comfort of a safety nest, nor do they have the return potential of equity.

Having said that, concepts like the Sharpe Ratio and standard deviation are highly relevant even while shortlisting long-only equity schemes.

C) Factor Investing

When it comes to long-only funds, where the fund is almost always fully invested in equity and gets judged based on outperformance to the benchmark, both in good times and in bad times, there are broadly two categories of funds.

Active funds: these funds endeavour to outperform their benchmark by leveraging the expertise of professional managers.

Passive funds: these funds endeavour to replicate the performance of a specific index by providing a ready-made product for investors who wish to buy the index. By construct, their performance lags the index due to their expense ratio, much less than active funds, and execution challenges they might face. This is also known as tracking error.

Worldwide, one of the most hotly debated investment topics is which strategy is better, passive or active. There are reams of articles on this subject, so we will not initiate that debate here.

We will however initiate another debate, which is that within the passive form of investing in equity, should one simply buy the bell-weather indices, for example Nifty 50, Nifty Next 50, Nifty Mid Cap etc, or should one consider factor indices?

1.Definition

Factor investing is a strategy that chooses securities on attributes that are associated with higher returns. In other words, an investment approach that involves targeting specific drivers of return across asset classes.

Like in everything in life, and more so in investments, once a strategy gains acceptance jargons seep into the narrative, and a multitude of options start competing. Similarly, in factor investing, a zoo of factors is now available. Which ones to choose for evaluation and invest?

After filtering the zoo of factors down to only those that have had explanatory power to predict above-market returns, a handful of factors have managed to grab the attention of institutions and investors.

• Value: the value factor is a strategy that helps investors identify undervalued stocks with the potential for long-term capital appreciation. It relies on components such as the price-to-earnings ratio, price-to-book ratio, dividend yield, price-to-sales ratio, and free cash flow yield.
• Momentum: the momentum factor refers to the tendency of winning stocks to continue performing well in the near term. Momentum is categorized as a persistence factor, that is, it tends to benefit.
• Low Volatility: the low volatility factor refers to the tendency of stocks with lower price fluctuations to outperform their higher-volatility counterparts over the long term, particularly on a risk-adjusted basis.
• Quality: the quality factor refers to the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets, and higher margins to outperform low-quality stocks, over a long-time horizon.
• High Beta: a basket of stocks that exhibits greater volatility than a broad market index.
• Dividend Yield: this one is well known, and we all would have, at some point, either bought shares basis its dividend yields or would have come across investors who applied this yardstick, or factor, to buy stocks.
• Size: the size factor refers to the tendency of small-cap stocks to outperform large-cap stocks over time.

2.Role of National Stock Exchange (NSE)

To provide a ready-made benchmark and to promote factor investing, the NSE helped the cause by creating several benchmarks. We focus on the following five:

Please see the annexure for the definition of these benchmarks. NSE's website has a lot more details and history.

3.Origin

In this section, we trace the origin of factor investing.

Before CAPM

Investors assessed the pluses and minuses of each company's stock based on its own merits, with little consideration of the relationship between one stock's performance and that of the market.

After CAPM

In the 1960s, with the advent of the Capital Asset Pricing Model, investors began to look at stocks through the lens of a stock's risk compared to the entire market.

Ri = Rf + beta * (Rm - Rf), where Ri is expected return from stock, Rf is the risk free rate, and (Rm - Rf) is market risk premium.

CAPM introduced Beta, as a factor, in stock selection.

Eugene Fama and Kenneth French Model

In the early 1990s, the release of a landmark study by Eugene Fama and Kenneth French introduced the concept of factors that could influence a stock's performance.

Their study focused on 3 factors - besides market risk, they added 2 more factors - size and value.

4.Performance

We have analysed the performance of 5 factors, as enumerated above - Value, Momentum, Low Volatility, Quality, and High Beta, and compared to the following 3 benchmarks - Nifty 50, Nifty Next 50, Nifty Midcap 50.

We have taken the benchmark data from NSE's website. Since the Quality factor benchmark was introduced only on January 1st 2009 we have taken the start date as Jan 1st 2009. As a result, the volatility witnessed in the 2 prior years does not get captured in our analysis.

One-year rolling return data: It is assumed that you invested every day, starting January 1st 2009 and exited one year hence. We have then computed the following - average return, median return, minimum return, maximum return, standard deviation, and Sharpe Ratio.

Five-year rolling return data: It is assumed that you invested every day, starting January 1st 2009, and exited five years hence. We have then computed the following - average return, median return, minimum return, and maximum return.

We have the data for standard deviation and resultant Sharpe Ratio. However, we are not sharing that for five year rolling returns. The reason being that over time, volatility reduces. Whilst that is good thing, usually volatility in the investment industry gets measured and quoted based on day-to-day market movement, which is far higher than the volatility if held for 5 years. And we did not wish to create any confusion, in the process.

Sharpe Ratio is a measure of reward-to-variability. It is a financial metric that compares the performance of an investment to a risk-free asset.

Return numbers are annualised.

D) Recommendation

In recent times, several Asset Management Companies have productized the factor benchmarks by launching ETFs and, or index funds which track these benchmarks.

However, barring a few schemes, the AUMs are still quite low. There are two main reasons for that: novelty factor - even though the benchmarks were launched more than 15 years back, active funds in our country have commanded a premium over passive funds. While allocations to passive funds have increased, the bulk has got allocated to the bell-weather index, Nifty 50. And low commissions - given that nearly 99% of the intermediaries earn by way of commissions, the percent fund pays to the intermediary is an important criterion. As compared to active funds, passive funds pay much less.

As highlighted earlier, the actual return of these ETFs and index funds is lower than the benchmark due to the tracking error.

We believe in following a well-defined asset allocation approach and within each asset class, we believe in sub-allocating to different investment styles. Factor investing does deserve an allocation. The percent of your equity portfolio that should go into factor investing will vary depending on your preferences and overall asset allocation.

Two caveats:

• You might come across articles that suggest timing the entry and exit into these factors. Please remember that it is hard to get the timing right. It is advisable to invest as per a defined allocation followed by regular re-balancing.
• Can you create your own factor benchmarks? Sure, you can. However, the tracking error and transaction costs need to be considered.

Annexure

Factor investing deserves a place in a disciplined equity portfolio, but it works best as part of a defined asset allocation framework, not as a shortcut to market timing.