Factor investing uses rule-based criteria such as value, momentum, quality and low volatility to select stocks through index-led mutual fund strategies.
In India, factor investing is a method of choosing stocks based on criteria like value, momentum, quality and low volatility. The strategy is rules-based; unlike fund size, ratings or past returns, it chooses stocks on set rules to form a portfolio.
Usually, index funds or ETFs tracking factor-based indices are the investment avenue for these types of investments in mutual funds. This is an article for educational purposes and not investment advice.
What Does a Factor Mean in Investing
A factor is a measurable quality used to group stocks with similar behaviour. Some stocks may appear reasonably valued, some may show strong price trends, and some may belong to companies with stronger financials.
In factor investing, these traits are checked through set rules. The rules decide which stocks should be included, how much weight each stock may get and how often the portfolio should be reviewed.
How Is Factor Investing Used in Mutual Funds
Most
factor-based mutual funds
in India follow an index fund or ETF structure. The fund tracks a factor index that has defined rules for stock selection, weightage, review and rebalancing.
This makes the process more rule-based and transparent. Before investing, investors should check the index method, scheme disclosures, risk level, expenses and tracking difference.
Here is how it generally works:
- The index provider starts with a broad stock universe.
- Stocks are checked on one or more factors.
- Stocks that meet the required score are selected.
- Weightage is assigned as per the index method.
- The mutual fund follows the updated index.
This keeps the process rule-based, although it does not remove market risk.
Which Popular Factors Are Used by Mutual Funds
Factor-based funds usually use traits that identify stocks on valuation, price trend, financial strength or lower price movement. The most common factors include value, momentum, quality and low volatility.
What Is the Value Factor
Value strategies look for stocks that may be available at reasonable valuations. They may use measures such as price-to-earnings ratio, price-to-book value, sales-to-price ratio or dividend yield. These funds may not perform well in every market phase. Value stocks can remain ignored for a long time, even when they look reasonably priced.
What Is the Momentum Factor
Momentum strategies select stocks that have shown strong recent price movement. They work on the idea that an existing trend may continue for some time. When market trends change, momentum-based funds may adjust their holdings more frequently than a regular index fund. This can make performance move differently from a broad market index.
What Is the Quality Factor
The quality strategy invests in financially healthy companies. These could be profitable businesses with manageable debt levels and strong operational power. This filter could avoid weaker companies, but these quality stocks will not avoid a sell-off in overall equity markets.
What Is the Low Volatility Factor
Low vol strategies try to identify and select the securities with smaller volatilities than the overall market. The objective is to reduce extreme movements in return. However, low volatility does not guarantee a stable return.
What Is the Difference between Single-Factor and Multi-Factor Funds?
A single-factor fund follows one main factor, such as value, momentum, quality or low volatility. However, a multi- factor fund utilizes a mix of two or more factors under one strategy.
A single-factor fund is less complicated, but can perform poorly during periods when that single factor is out of favor. Multi-factor funds might offer more equilibrium but are prone to market risk, and do not suit all market conditions.
How Are Factor Funds Different from Active Funds
In an active fund, the fund manager studies companies and takes investment decisions within the scheme mandate. In a factor fund, the main selection process follows the index method.
The fund manager’s role is mainly to track the index closely and manage the fund as per the scheme structure. This makes factor investing more rule-based, but it does not make it risk-free.
Where Can Factor-Based Mutual Funds Fit in a Portfolio
Factor-based mutual funds may suit investors who already understand basic equity mutual funds and want to add a specific style to their allocation. These funds are usually better used as one part of an equity plan, not as the entire investment plan.
They may add a defined style, reduce complete dependence on stock picking and offer a transparent rule-led approach. The suitability depends on the investor’s risk profile, time frame, existing investments and overall financial goals.
What Should Investors Check before Investing in Factor Funds
Before choosing any factor fund, investors should read the scheme document and understand the index being tracked.
The points to be checked in a fund are:
- The factor being applied by the fund
- Index methodology
- Expense ratio and tracking difference
- Sector concentration
- Rebalancing frequency
- Fund overlap
- Risk profile and investment goal
With these checks, investors will not blindly buy a fund because it has done well recently.
FAQs
Factor investing means selecting stocks based on fixed traits such as value, momentum, quality or low volatility. In mutual funds, this is usually done through an index-led method.
Most factor-based mutual funds follow an index fund or ETF structure. The stock selection is based on the index method, while the fund manager mainly tracks the index.
A beginner should start with conventional equity mutual funds and then build up with factor funds. A factor-based fund can work well for an investor with adequate knowledge of market risk and the ability to sit through poor cycles.
No. Factor funds should not form the entire equity allocation. They can form a part of a larger portfolio, keeping in view an investor's goal, comfort level with risk and the investment timeline.
No. Factor funds can perform better or worse than broad market funds depending on market conditions. No single factor works well in every phase.
Final thoughts
Factor investing can give investors a more structured way to invest instead of choosing funds only by recent returns. It works best when the investor understands the factor, the index method and the role of the fund in the overall portfolio.
Factor-based mutual funds may add a clear investment style, but they still carry market risk. Before investing, check whether the strategy matches your risk comfort, time frame and financial goals.
Disclaimer: Cholamandalam Securities Limited (CSEC) is a SEBI-registered stock broker and depository participant. CSEC does not provide investment advisory services. Investors are advised to consult an independent financial advisor before taking any investment decisions.