Right time to be investing in factor funds, says Edelweiss MF’s Bharat Lahoti

As of May 2024, Edelweiss MF’s factor-based investing AUM is around Rs 14,000 crore.

When it comes to factor investing, a multi-factor approach works best, said Edelweiss Mutual Fund’s Bharat Lahoti. “Incorporating quality, value, growth, and momentum helps capture business cycles over time and manage risks associated with any single factor's underperformance,” said Lahoti, Co-head, Factor Investing.

As of May 2024, Edelweiss MF’s factor-based investing AUM is around Rs 14,000 crore. In a conversation with Moneycontrol, Lahoti spoke about why Edelweiss is betting big on factor-based investing, and the benefits it holds for investors. Edited excerpts:

What is factor-based investing?

Factor-based investing, known globally as smart beta, involves taking into account factors like value, growth, quality, and momentum. This helps in managing behavioural biases and making rule-based investment decisions.

Why is it gaining popularity now?

For one, it removes behavioural biases by following rules and avoiding subjective calls. For example, small-cap funds were regarded expensive last year, but they still outperformed other categories by a wide margin. Factor investing adapts well to shorter market cycles and high liquidity, especially when passive investing flows are strong. Different factors (value, growth, momentum) perform well at different times globally. In India, growth, quality, and momentum are key. Momentum, in particular, has been the hallmark of the recent rally because of aggressive money flows.

How do you balance the risk of a factor not performing well during different cycles?

It is true that at different times, different factors do well. For example, between 2000 to around 2020, value was not doing well, so most fund houses were looking at growth. Recently, value and momentum have been doing well. We prefer to use a multi-factor model, incorporating quality, value, growth, and momentum to capture business cycles over time. This diversification helps manage risks associated with any single factor's underperformance.

How do you construct a factor-based portfolio?

To calculate a growth factor index, we rank stocks based on sales growth, EBITDA growth, and profit growth. For example, in a universe of 100 companies, we rank them from one to 100, with 1 being the best in sales growth and 100 being the worst. We consider the last four quarters' performance, selecting the top quartile (25 stocks) for the growth index. For growth, we look at sales growth, EBITDA growth, and profit growth. For value, we consider price-to-earnings, price-to-book value, EV/EBITDA, and dividend yield. For quality, we use ROE, ROC, and leverage ratio (debt-to-equity). For momentum, we examine three and twelve-month past performance.

How do you manage portfolio churn in a factor-based model?

Portfolio churn depends on strategy. Some funds churn four times a year, while others churn eight times, capturing market trends and earnings momentum. This higher churn is compensated by better alpha generation due to a rule-based approach.

What should investors look for in factor-based funds?

Investors should look for funds that are data-driven, evidence-based, and offer controlled risk management.

What is the difference between active and passive factor-based investing?

Active factor-based investing allows fund managers to adjust portfolios based on market conditions, while passive factor-based investing follows fixed rebalancing schedules. Active management often uses a multi-factor approach, offering better risk management.

Your latest NFO Business Cycle Fund is built on this model. Tell us how it works.

The Business Cycle Fund aims to solve sectoral timing issues and generate alpha by using a rule-based, multi-factor approach. It selects factors like growth, value, quality, and momentum, building a portfolio based on where these factors are performing well. This method provides better timing and sector allocation, enhancing alpha generation compared to traditional diversified funds.

What are your expectations from the upcoming Budget?

Recent announcements from the government suggest a shift towards populism, contrasting with the previous focus on supply side issues to control inflation and create jobs. Consumer stocks have struggled due to weak rural incomes and controlled agricultural inflation. If trends reverse, FMCG stocks, especially consumer discretionary, could gain. The fiscal deficit is stable, aided by RBI funds, allowing for potential populist measures and continued Capex. The defense sector is expected to maintain robust Capex, with minor improvements in the revenue-to-capital expenditure ratio. However, large populist measures are unlikely.

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