What is factor investing?

Why do some groups of shares behave differently from the market for long periods? Factor investing tries to answer that. This page explains what factors are, the main ones researchers study and how factor investing is used in India.

Quick answer

Factor investing is an approach that selects shares based on specific traits, called factors, that research has linked with differences in risk and return over long periods. Common factors are value, size, momentum, quality and low volatility. Instead of buying the whole market by size, a factor investor tilts a portfolio towards shares with chosen traits.

Key takeaways

• Factors are traits that help explain share returns.
• Main factors are value, size, momentum, quality and low volatility.
• Fama and French's 1993 model made factors widely known.
• Factor index funds and ETFs are available in India.
• Each factor can lag the market for long periods.

What is factor investing?

A factor is a common trait shared by a group of shares. For example, cheap shares share the value trait, and shares that have risen strongly share the momentum trait. Researchers found that some of these traits help explain why returns differ.

Factor investing builds a portfolio around one or more of these traits. It sits between passive investing, which simply follows an index, and active investing, which relies on a fund manager's judgement.

Where did the idea come from?

The capital asset pricing model, or CAPM, used one factor: the market. In 1993, Eugene Fama and Kenneth French added two more, size and value, in their three-factor model. Mark Carhart later added momentum in 1997.

Since then, researchers have studied quality and low volatility as well. These five are the factors most often used in practice today.

The main factors explained

Each factor has a reason behind it. Some see factors as a reward for taking extra risk. Others see them as a result of investor behaviour, such as people overpaying for exciting shares.

Factor investing in India

NSE Indices publishes factor indices such as the Nifty200 Momentum 30, Nifty100 Low Volatility 30 and Nifty200 Quality 30. Several mutual funds offer index funds and ETFs that track such indices.

These products follow published rules, so investors can read the index method to see how shares are chosen and how often the list is changed.

Risks of factor investing

No factor works all the time. Value, for example, has gone through long periods of lagging the market in many countries. Momentum can reverse sharply when market direction changes.

Costs, crowding and changes in the market can also reduce what a factor delivers. Past performance is not indicative of future results, so it helps to understand a factor before choosing a product based on it.

The securities and commodities named here are mentioned only to explain how the market works and are not a recommendation to buy, sell or hold them.

Frequently Asked Questions