How Factor Investing Works

Factor investing works by targeting specific, identifiable characteristics of stocks that have historically delivered better returns than the broader market. Instead of picking stocks based on a fund manager's conviction or simply tracking an index, factor investing builds portfolios around measurable traits — called factors — that research has shown to drive returns over time.

The most widely recognized factors are value, quality, momentum, low volatility, and size. Each one captures something specific. Value targets stocks that are cheap relative to their earnings or book value. Quality focuses on companies with strong balance sheets, high returns on equity, and stable earnings. Momentum backs stocks that have been rising on the theory that trends persist for a while before reversing. Low volatility picks stocks that swing less than the market, which, counterintuitively, can deliver decent returns with lower drawdowns.

The reason these factors work is rooted in a mix of risk and human behaviour. Value stocks look cheap because investors are uncomfortable holding them — the underlying business may be in a slow patch. That discomfort creates a discount, and when things normalize, returns follow. Momentum works because investors are slow to react to new information, so a stock rising on improving fundamentals could be underpriced for a while. Quality works because investors could underestimate the compounding power of a genuinely good business.

In practice, factor investing is implemented through rules-based strategies. A single factor or multi-factor fund would start with screening the investable universe using quantitative criteria, score stocks on the chosen factor or factors, and build a portfolio of the highest-scoring names. There is no subjective judgment involved.

Factor investing reduces behavioural bias in portfolio construction. Traditional investing depends on a fund manager’s judgment and market outlook, which can at times get influenced by emotional biases such as chasing popular stocks or reacting too strongly to recent trends. Factor strategies, by contrast, rely on systematic and data-driven rules to identify stocks with specific characteristics. But remember, no single factor can work well all the time.

Factor investing is often described as a “smart beta” approach because it sits somewhere between passive and active investing. It retains the transparency and rule-based framework of passive strategies but introduces targeted factor exposure with the aim of generating better risk-adjusted returns over the long-term. In that sense, it combines elements of both worlds — systematic like passive investing, but more selective in how the portfolio is constructed.

A multi-factor approach helps smooth out the periods when individual factors may see underperformance. A multi-factor fund blends two or more factors in a way that reduces the risk of any single factor dragging performance for too long, since individual factors. These factors partially offset each other through different market conditions. Edelweiss Nifty Alpha Low Volatility 30 Index Fund is an example of a multi-factor fund.

Different factors tend to outperform at different stages of the market cycle. Combining them in a multi-factor strategy can therefore create a more balanced portfolio that performs more consistently across changing market conditions.

Disclaimer: Nitin Bellara is the Managing Partner at Zeus Distribution House and the views expressed above are his own.

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