Investment approaches can be touted as the core of the strategic management of a mutual fund portfolio. By carefully selecting assets that potentially encourage higher returns, you can capitalize on the overall gains in your portfolio. One such approach that can promote portfolio diversification with potential higher returns over long run is factor investing. All assets inherently have specific attributes that can potentially drive higher returns in long run. Let’s call them catalysts. These catalysts can shape your portfolio to manage returns during different market cycles.

Therefore, factor investing is a strategic investment approach that focuses on certain catalysts of different assets associated with higher returns. Factor investing aims at three investor-centric objectives:

• Help generate returns

• Help increase portfolio diversification

• Help mitigate overall market risks

How do factor investing and returns co-relate?

Every investor has the natural craving to earn higher returns, and a factor investing approach has the potential to satisfy it. However, earning returns higher than the benchmark isn’t easy, as the market doesn’t come with favorable conditions all the time.

The mutual fund portfolio can give two types of returns: market returns and excess returns. The returns on the portfolio generated due to market conditions are market returns. The returns achieved above or beyond the expected market returns are called excess returns. Does factor investing truly have the potential to generate excess returns? The answer is vague, but through trials and errors and managing market risks, one can hope.

Which factors are considered in factor investing?

Factor investing requires studying two important factors: macroeconomic factors and style factors. Macroeconomic factors involve inflation rates, unemployment rate, etc., whereas style factors involve growth vs. value stocks, market capitalization, industry sector, etc.

Analyzing macroeconomic factors is crucial for understanding the broad risks associated with the asset classes, while style factors explain the risks and returns. The fund manager aims to develop the portfolio by allocating assets based on these catalysts with potential money-generating characteristics like value, company size, etc.

Important factors explained

Value

Value criteria involve buying underpriced assets that have low prices relative to their fundamental values. The fund managers measure value using the price-to-earnings ratio, free cash flow, the dividend amount, etc.

Size of the company

The market cap size of the company can also influence returns. Factor investing usually considers small-cap or mid-cap companies. Small-cap or mid-cap companies tend to have growth potential, which may give reasonable returns in the long run. However, do not totally depend on the past data for future investments.

Quality of the company

Financially healthy companies can be good investment options. Such companies can be defined by low debt ratios, potential high equity returns, consistent asset growth, etc. Investors also shouldn’t expect immediate returns due to market unpredictability but can consider reasonable returns in the long run.

Volatility

When volatility is considered one of the factors in factor investing, research suggests that low-volatile stocks have potential to earn better risk-adjusted returns than high-volatile stocks. But choosing volatility also depends on your investment objective—less volatile stocks aim for steady income generation and higher volatile stocks for capital appreciation. The standard deviation can be used to understand the volatility of stocks.

Momentum

Investors can observe the market trend line of a particular stock to understand its past performance. The market can speculate that stocks that have performed well in the past and can continue to appreciate in the future. Therefore, the past performance of the stock is the measure used. To study its performance, investors must consider a time frame of 1-3 years.

Conclusion

Factor investing can offer you one way to capitalize on your gains. If your investment intent involves taking risks and capital appreciation, factor investing may be a suitable option. Studying new investing strategies can expand your ways of earning capital wealth. But figuring out your preferred investment style is also important.

Past performance may or may not be sustained in the future. Aditya Birla Sun Life AMC Limited /Aditya Birla Sun Life Mutual Fund is not guaranteeing/offering/communicating any indicative yield/returns on investments.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.