Smart-beta funds work in India, but a sprinkle of active stock picking works better: Union Mutual Fund study

Thirty-four smart-beta funds together manage assets worth Rs 6,116 crore.

The good and bad of factor investing

Occupying a sweet spot between active and passive investing, factor investing provides investors with the tools to express investment views in a cost-efficient manner while adhering to the discipline of a rules-based approach mitigating biases. To put it simply, factor investing entails picking up stocks based on certain pre-set filters or rules. Once the fund house sets these filters, it makes a model portfolio of stocks picked using these. In the past couple of years, stock exchanges too have developed such factor indices, in collaboration with fund houses. These factor indices are then updated periodically. Schemes benchmarked against them, and churn their portfolios accordingly. These are also known as smart-beta or quant funds.

Factor investing funds look similar to passive funds, like index funds. But they are slightly more active, but not so much as actively-managed funds. While index funds are based on broader stock market indices that pick stocks as per their free-float market capitalisation, factor funds use a combination of ratios and strategies to pick stocks.

For this study, Union MF studied four factors; growth, quality, value and momentum. Here are some of its findings.

For growth investors, there is good news. Shares of companies posting above-average growth had done better than their below-average growth counterparts in seven out of nine three-year periods, ended June 30, 2022.

It gets better. If a fund manager would have constructed his portfolio on the basis of future (expected) growth using his own stock picking skills and the principles of the said ‘factor’, then again he would have outperformed in all the nine years with the help of above-average growth companies.

“Business growth is strong predictor of future stock returns. Growth premium exists in the Indian market. Future growth has a stronger influence on future returns than past growth,” says the report.

Shares of companies with above-average quality business and shares of companies that are available at cheap valuations too have demonstrated similar outcomes. Keeping aside the last two years, growth, quality and value did well in the seven years preceding that.

The last factor, momentum, is the trickiest to navigate. A momentum strategy picks stocks based on recent performance. Seven out of 10 times, one-year returns of the strong momentum portfolio have outperformed that of the weak momentum portfolio. More important, it has been erratic, as the momentum factor is not consistent—quite often, a year with a strong momentum winner is followed by a weak momentum outperformance and vice versa.

“Forward-looking prospective data which involves fundamental analysis and human intervention has delivered consistently robust results compared with backward-looking retrospective data relying on purely historical data analysis. Hence, fundamental research with forecasting has to be blended with quantitative factors to deliver superior results,” the report says.

Put simply, an actively-managed diversified equity fund where the fund manager gives due weightage for prospective growth, quality and value among other parameters while selecting stocks may be a good bet for wealth creation.

The space for factor funds in your portfolio

All fund managers swear by a method to pick stocks. Your fund manager could use one or a combination of these factors to pick stocks.

But there is a catch: Each of these investing strategies or factors have periods of outperformance and underperformance.

“Investors should ideally build a portfolio that is diversified across investment styles. It helps to stay put when an investment style goes out of favour. Though each investment strategy based on a single factor has delivered returns in the long term, the intermittent periods of underperformance can be unnerving,” says Arun Kumar, head of research, FundsIndia.com.

In reality, it’s hard to pick one factor over another, because each of these factors works simultaneously. Experts say that investors should ideally not look at each one of them in isolation.

Nirav Karkera, head of research, Fisdom, an investment services platform, says, “Though a stock may be selected in alignment with a factor strategy, its performance may not be attributable to that factor only. A combination of factors are at play at any given moment of time. Some factors may influence the stock price more in a given environment.”

Globally, growth-oriented portfolios did better compared with value-focused portfolios in the decade ended CY2020. Each factor may have periods of outperformance and weak performance.

Ravi Kumar TV, founder of Gaining Ground Investment Services, says, “Typically, in a recovery phase, value investing does well. In an expansionary phase, the market does well and momentum generally gives very good returns.”

Industry experts are clear that for most investors it makes sense to go with multi-factor strategies. Karkera recommends multifactor strategies for core portfolios.

“In case of satellite portfolios, depending on the market environment, investors may choose between a single-factor strategy and a multifactor strategy. If you are keen on a single-factor strategy for the long term, then stick to strategies such as quality or growth that focus on business fundamentals than strategies such as momentum that focus on price action,” he adds.

Should you invest in factor funds?

Factor schemes are here to stay and more fund houses are expected to launch them. Fund houses that swear by active funds are expected to tilt more towards factor-based funds than pure-play index funds. This makes business sense too for them. As opposed to only a limited number of index funds that fund houses can launch—which depend on the total number of indices available on a free float market cap basis—new factor indices can be developed by using a combination of parameters.

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More importantly, factor-based or smart-beta funds come with a higher expense ratio than index funds.

Smart-beta funds do not yet have a long-term track record in India, although some schemes have managed to differentiate themselves. If you are starting out on your investment journey, take a look smart-beta funds, but build your portfolio mostly around active and passive funds, to begin with. Choose a smart-beta fund depending on the strategy that suits your risk profile the most.