Multi-factor strategy: Factor premiums are returns that are adjusted for risk and have a strong economic or behavioral reason for being the way they are. Value, momentum, quality, low volatility, and size are the most common ones. For factor investing, you put together a portfolio of stocks using parameters that represent a certain factor. For example, you can buy value stocks if they have a high ratio of sales to price or a high ratio of earnings to price. In the same way, a different parameter stands for each factor. Factor-based portfolio construction lets you test rules over decades.
This helps figure out how stable the factor is over both large and small time periods. The stocks in traditional discretionary funds are chosen by the skills of the fund manager. For many traditional funds, you have to look at how well the manager has done in the past to know how good they are. It can be hard to find enough money with a long history that can be used for this. On the other hand, factors are easy to test over a long period of time.
A factor-based model, on the other hand, can’t use a lot of the qualitative information that an experienced manager can. Investing based on factors and investing based on the choices of the investor work well together. Anyone who wants to invest should think about putting both in their portfolio.
Why does investing in momentum work?
The momentum factor is a measure of how the price of a stock changes over time. It is a behavioral factor. A momentum portfolio is made up of stocks whose total returns are higher than those of their peers. The idea behind momentum is that this trend is either going up or down. Which is caused by how people feel about the market, will last for a while, and can be used to make money.
It is one of the most stable factors that has done well in markets around the world and in India. Even though the factor has very high returns, it also has big losses when markets are going down. With a high risk-adjusted return, investors can make a lot of money over time. If you don’t like how volatile momentum is, you can combine it with quality or value to reduce drawdowns.
How important is it to invest in factors when inflation is high?
Professional fund managers, especially in the US, have used factor investing for many decades. Academic research and backtesting have shown that it has worked for more than a century of available data. Even though macro events like inflation can affect factors, their medium-to-long-term risk-adjusted premiums are strong. Factor investing can adapt to market cycles even though macro events can affect returns in the short term. A multi-factor strategy reduces the cyclicality of a single factor return because not all factors are affected by the same macro event.
A quick look at how investing in India and other places is changing.
Academic research in “factor investing” has led to a new investment product category. The 1993 seminal paper by Nobel Laureate Eugene Fama and Kenneth French put factors into a solid framework. The value premium, size premium, and market exposure all affect returns, according to this paper. This started a lot of work on factors, and now we have more than 300 documented parameters in different factors.
This led to the creation of a number of investment products. Factors are used as long-only products by mutual funds and smart beta ETFs, while hedge funds use them for long-short strategies. Factor-based products have been used successfully around the world for a long time. Over time, rule-based quantitative models have slowly started to take over the market share of traditional discretionary managers, and this share has kept growing. A lot of the best hedge funds use quantitative methods to manage assets worth hundreds of billions of dollars in alternative products. The assets for these quantitative strategies come from a wide range of institutional and individual clients. It’s a way for organizations to use money to make more money over time.
In India, where quantitative factor-based funds and smart beta ETFs have been growing for years, a similar journey is about to begin. Factor-based investing is something that investors and advisors are learning about. Investors have put more money into these factor-based funds because they see the same chance of making money in them. As investors learn that factor investing has high risk-adjusted returns and stays consistent through market cycles, it will become a big part of their core allocation.
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How does the fact that multi-factor strategy are always the same fit into the World of Investing?
There are strong economic or behavioral reasons why each of the factor premiums exists. Several places have shown that this premium stays the same over the medium to long term. But each factor has a different effect on the market at different times. In the short term, this makes a single factor cyclical. Risk-adjusted returns from factor investing have been shown to be stable over a long period of time, not only through academic research and backtesting with historical data, but also through the strong live performance of factor-based funds around the world and in India.
Investing in factor-based strategies regularly and with patience has been shown to be a great way to build wealth over time. The rule-based method also has the advantage of making it clear how stocks are chosen and how returns are calculated. This is one of the main reasons why it has been so successful around the world in both institutional and retail settings, and why it is also growing in the U.S.
How can a multi-factor strategy with multiple factors help you build your portfolio?
As was said above, due to different macro business cycles, single factors have high risk-adjusted returns that are also more volatile and cyclical. But the different factors don’t have much in common because the reasons why their premiums don’t change are all different. When you combine quality, value, low volatility, and momentum for a smoother risk-adjusted return, low correlation diversifies. Factor strategy returns outperform the market benchmark over time, so investors should use them to build wealth.
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