Your Money: Factor investing for volatile times
By Vineet Sachdeva
Factor investing tries to generate alpha by capitalising on market biases and systematically identifying drivers of return. It is well-positioned to deliver reasonable risk-adjusted returns with increased market efficiency and technological advancements.
Market volatility
As volatility is expected to increase, investors are expected to increasingly exhibit behavioural biases such as overreaction, herd behaviour, and loss aversion. These anomalies create opportunities for factor investing because of its disciplined approach. Momentum thrives in bull markets as investor sentiment drives prices higher, while value captures opportunities when investors overreact and sell off fundamentally strong stocks during market downturns.
Factor rotation and adaptive models
Different factors perform better in different phases of the market cycle such as momentum in turnaround markets, and quality and low volatility during downturns. Low volatility and quality factors provided downside protection. An adaptive factor model would rotate between these factors dynamically to optimise risk-adjusted returns. Factors tend to be more resilient over time and are pervasive, thereby generating alpha over longer periods of time if one gets the alignment right.
Growing investor sophistication
Indian investors are becoming increasingly sophisticated, with growing awareness of factor-based (Smart Beta) strategies through education, rise of factor ETFs, and increased use of quantitative approaches by asset managers. As this awareness grows, demand for factor-based products will increase, promoting greater adoption of multi-factor strategies. Factor ETFs such as those focused on quality, value, and momentum are gaining traction among retail investors.
Tech advancements
Artificial intelligence, machine learning, and Big Data in investment management is set to enhance factor investing’s effectiveness. These technological advancements will allow for sophisticated factor models that can process vast amounts of data in real time, improving factor selection, risk management, and portfolio optimisation.
Alignment with ESG goals
Factor investing can be designed to align with the investor’s Environmental, Social, and Governance (ESG) goals. Quality and low volatility factors tend to be high on ESG scores as they lay emphasis on corporate governance and financial discipline.
Although specific factors like value, momentum, quality and size have performed well in the long term, there are significant periods of underperformance with using single factor models. This can test investor patience over these periods. The challenge is therefore to find the right tilt towards factors for a specific market environment.
The writer is entrepreneur partner, Quantitative Equity Investing, Alpha Alternatives.
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