Mutual funds take to factor-based investing; bridging active, passive gap

Use parameters such as momentum, company size, and volatility to construct portfolios

The domestic mutual fund (MF) industry is witnessing a shift with factor-based investing, bridging the gap between active and passive approaches.

At least three fund houses now manage active funds using factor-based models, while others are exploring this space through quant and active-momentum funds.

Factor-based investing employs investment models based on factors such as momentum, company size, value, and market volatility, to construct portfolios.

These schemes can be both active and passive, with active offerings using multiple factors and adapting to market cycles.

The factor funds on the active side are also referred to as smart-beta funds. This investment approach is also known as rule-based and “quantamental” (portmanteau of quant and fundamental) investing.

The other difference between active and passive funds is that in active funds the final call on stock selection and weights generally lie with the fund manager. Factor-based passives, on the other hand, go about investing with a set formula. This could be “low volatility”, “dividend yield” or “momentum”.

At present, Edelweiss MF manages the equity portion of four of its active funds through this strategy. The funds include its balanced-advantage fund, aggressive-hybrid fund, largecap fund and the recently-launched business-cycle fund.

The fund house manages around Rs 16,800 crore in these schemes.

NJ Mutual Fund has been managing all its equity and hybrid funds through factor-based strategies since inception in 2021. Shriram MF joined NJ as a fully factor-based investing fund house last year as it revamped its equity investing approach in September 2023.

Fund houses, which have opted for factor-based investing for their active funds, say the decision was driven by the comparative advantages that they hold over the traditional investment approach. The latter largely involves stock picking based on fundamental parameters.

“Factor investing addresses various investing challenges, and we apply this approach in funds where we believe factor investing can be more suitable compared to fundamental investing. For instance, we recently launched a Business Cycle Fund using factor investing to solve the sector rotation issue. Here, the momentum factor enables faster sector rotation compared to the traditional top-down investing approach,” said Radhika Gupta, managing director (MD) & chief executive officer (CEO), Edelweiss MF.

“The ‘quantamental’ approach makes you process oriented, leading to better speed and efficiency. As opposed to investing based on subjective calls, the data-driven approach helps build a more sustainable model in the longer run,” said Deepak Ramaraju, senior fund manager, Shriram Mutual Fund.

The fund house has seen some success in the first year with several of its offerings improving their rankings in the returns chart.

According to MF executives, the approach is also more cost efficient and gives an edge on the cost front.

“Such strategies are highly cost-effective for the asset management company (AMC), as they allow it to manage more assets with fewer resources,” said Gupta, adding that a five-person team at the fund house manages around Rs 35,000 crore.

Other fund houses are experimenting with factor investing for specific products. The active thematic category so far has two different types of products — quantamental or quant and active momentum.

There are 10 quant funds and they together manage around Rs 9,200 crore. Market leader SBI MF is likely to launch a quant fund in the coming months.

At present, there is only one active momentum fund, that of Samco MF. Two more launches are lined up in this category.

Making Money
 

Key factors used in investing
 

Momentum: Identifies stocks that have strong recent performance
 

Value: Filters stocks based on valuation multiples to figure out undervalued opportunities
 

Quality: Stocks with strong fundamentals, high profitability, and stable earnings
 

Low volatility: Stocks that show comparatively lower price movements