'No human bias is involved as happens in active funds.'
Factor-based funds, also called smart-beta funds, have done well year-to-date.
Momentum-based factor funds have outperformed owing to high momentum in the equity market in recent times.
The broad-based nature of the rally has helped the equal-weight strategy do well. But before you decide to invest in these funds, understand how they work.
What is a factor-based fund?
These are rule-based funds. A universe is defined and then a few filters (or criteria) are applied to it. The stocks obtained are ranked in descending order. Those that rank higher are given a higher weight in the factor index.
An index like the Nifty 50 is a free float market cap-weighted index.
Says Sharwan Goyal, fund manager and head-passive, arbitrage and quant strategies at UTI Asset Management Company: "This is an alternative way of index construction based on either fundamental (quality, growth, value) or market (momentum or low volatility) based factors, as compared to the traditional market cap oriented factor."
The goal, he adds, is to generate better returns or risk-adjusted returns than the parent index.
The Nifty 200 Momentum 30 Index, for instance, is derived from the Nifty 200. Stocks are selected on the basis of recent price momentum.
"Those stocks that have performed better in the recent past get selected with the belief that momentum would persist going forward," explains Goyal.
Over the long term, these indexes have beaten their parent indexes.
The Nifty 200 Momentum 30 Index has generated significant alpha (around 5.6 per cent compounded annually) since inception over the Nifty 200.
Factors such as low volatility, quality, value have also shown better outcomes than broad market cap indices since inception.
No human bias
Factor-based funds are rule-based.
"No human bias is involved as happens in active funds," says Alekh Yadav, head of investment products, Sanctum Wealth.
Every fund manager also follows a particular style, which inevitably witnesses periods of underperformance.
"When this happens, the fund manager comes under a lot of pressure. There is a temptation to deviate from the style. Such deviation does not occur in a factor-based fund," says Arun Kumar, head of research, Fundsindia.com.
If an investor holds a factor-based fund for 7-10 years, there is bound to be a stretch, sometimes prolonged, when these funds drastically underperform a market cap-based index.
The quality factor is underperforming currently and value had done so earlier.
How to make them work for you
In any given market environment, which may last for two to three years, some factors do well and others don't. As market sentiments and economic cycles change, so do the outperforming factors.
"Build a portfolio combining four to five different factor-based funds and let them run for a 7-10-year timeframe," says Kumar.
Adds Goyal: "Having some allocation to different complementary factors may bring down portfolio volatility by providing diversification, and improve portfolio performance over time."
Combining momentum and low volatility, for instance, has worked historically.
What to watch out for
Figure out which factors have done well historically in the Indian market and hence deserve to be included in your portfolio.
While some factor-based indexes may have given high returns historically, running a fund based on them may not be easy.
Says Kumar: "The momentum strategy, which is high-churn, is difficult to implement once asset under management (AUM) grows large. There is an impact cost."
Any strategy that requires investing in illiquid stocks is also difficult to implement. These issues can create a gap between the performance of the index and that of the fund.
Currently, most factor funds don't have a long track record, so investors cannot check their tracking errors.
"When selecting factor-based funds, take into account fund size, churn, and liquidity of the stocks that need to be purchased," says Kumar.
According to experts, most active large-cap funds may not be able to outperform their benchmarks.
"A factor-based fund may be able to provide some alpha in this category," says Yadav.
Kumar says investors who decide to blend four or five factors may include them in their core portfolio.
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Feature Presentation: Ashish Narsale/Rediff.com