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By Bijon Pani, Chief Investment Officer, NJ Asset Management Private Limited

Factor investing is a method of choosing stocks (or other asset classes) using a predefined set of rules or parameters. The science of how to choose these parameters is what determines how successful the factor is in future. When choosing a factor, one needs to make sure they are robustly constructed, should work across multiple countries, and have a sensible rationale on why it works.

Factors offer a way of segregating a diversified portfolio returns (such as those of a fund manager you might like) into its various factor components and what then remains unexplained is the contribution of the manager.

The first example of using factors to explain returns comes from the CAPM model which showed risk and return in terms of the market exposure. But the CAPM left a lot of the return unexplained. There were multiple influential academic papers which put forth other factors such as value and size to explain returns.

It was Fama and French in 1993 who conceived a simple framework to think about returns in terms of factors. They added two powerful factors: value and size to the existing market return factor. It was further enhanced by Carhart to include momentum.

The four factor model became the bedrock of performance and risk analysis of fund management for many decades. Over time as the computing power became faster and more accessible, the academic research into factors exploded as crunching data became easier. The latest innovation uses machine learning, natural language processing and alternative datasets. There are now hundreds of documented parameters, even though most of them fall into one of the four factor styles: value, quality, low volatility and momentum.

John Cochrane, a leading academician who studies factors, rightly calls this the factor zoo. The job of a practitioner has been made hard as newer parameters keep getting reported that promise better returns compared to the older ones. It is especially more nuanced and harder when it comes to factor investing in India. This is because India suffers from two big issues.

Firstly, liquidity is a big problem beyond a certain number of stocks and when one is constructing factors, you need a large enough universe to measure the factor premiums and construct portfolios. This job gets harder if the universe has illiquid stocks as one may end up including stocks in portfolios that cannot be easily invested in.

Secondly, factor construction requires long clean data and we often suffer from inadequate and patchy data. This requires the skills of an experienced professional who can craft the factors specific to the Indian markets without losing the essence of it. It is, after all, very easy to fall into the data-mining trap and construct parameters that have worked in the past but may not in the future.

Once factors became common in the developed world, they made the life of traditional fund managers even more challenging. It wasnt easy beating the market index, but now with added factors, the overwhelming majority (more than 90 per cent by some research) couldnt beat a portfolio constructed using factors.

Morningstar India research found that only 26 per cent large cap discretionary funds could beat the benchmark over the past 10 years. The average alpha was a mere 1.15 per cent. This alpha may have been negligible if we added other factors in the regression. The future of fund management in India will be very similar to that of the west, we will see active factor based funds giving a strong competition to discretionary fund managers in providing better risk adjusted returns. The charts shows the performance of various factors and an equal weight multifactor portfolio (constructed from the 4 factor indices published by NSE) compared to the market over the last 10 years. Readers will notice that the performance of various factors and the multifactor model was better than the index during this time. On a risk adjusted basis, the numbers are even better.

Our retail participation in mutual funds is very low, over the near future as more money flows into funds, quant funds will not just grow along with traditional funds but also increase their market share. A rule based approach allows the parameter to be backtested and see how it has performed over various business cycles. This provides an added confidence in the risk and return structure of the portfolio.

The only word of caution we would like to add is that even though rule based investment strategies will grow rapidly in future, it would mostly be in the active approach where effort is invested in studying factors in the Indian context. Simply copying parameters from the developed market into India may not work very well, so rule based strategies need to be constructed keeping in mind the idiosyncrasies of Indian markets, not just replicating an index.

Factor. investing has moved from being a fundamental concept of academic finance to the next disruptor in fund management.

(Disclaimer: The views expressed above are the authors own views.)

Read the original post:

Factor Investing the road ahead - The Financial Express