Select index factor fund based on high conviction and risk appetite

Ajay Singh (name changed on request), a 35-year-old Noida-based lawyer, plans to invest in factor (or smart-beta) funds in 2025. However, upon reviewing their performance, he found that their returns vary significantly from year-to-year. While the alpha index outperformed in 2024, value led in 2023 and 2022. With so much variation in performance, how should retail investors like Singh choose a factor index fund or exchange-traded fund?

 

A market cap-based index selects and assigns weights to stocks based on market cap, favouring larger companies. In contrast, factor-based indices select and give weights to stocks based on specific characteristics and parameters, like momentum, value, quality, and so on.

 

 

Ability to outperform

 

Market cap-based funds mirror index returns. Factor funds have the potential to outperform broader market indices. They also have lower expense ratios than active funds.

 

“These funds do not carry fund manager risk,” says Deepesh Raghaw, a Securities and Exchange Board of India (Sebi)-registered investment adviser (RIA). The risk of poor fund manager decisions or changes in manager does not affect them.

 

Spells of underperformance

 

No single factor index, however, outperforms consistently. “Performance rotates. The factor you pick can go through a reasonably long bad patch lasting two–four years,” says Raghaw.

 

Even when a factor index performs well, funds tracking it may fail to replicate those returns. “This could happen due to costs, cash allocation, and difficulty in executing the strategy because of the illiquid nature of stocks that have to be picked,” says Arun Kumar, head of research, FundsIndia.

 

Passive stock selection can also bring into the portfolio companies with weak corporate governance.

 

Varied historical performance

 

Historical data show varied performance among factor indices. “Momentum has delivered the maximum returns since April 2005, though with higher volatility. Low volatility has provided the best risk-adjusted returns with the lowest volatility. Value and quality styles are more cyclical. Their performance keeps shifting across cycles,” says Sharwan Goyal, fund manager and head, passive, arbitrage, and quant strategies, UTI Asset Management Company.

 

Core portfolio approach

 

One approach to factor investing can be to select multiple factor funds for the core portfolio. “Include five different styles: quality, growth, momentum, value, and mid and small (treating size also as a factor). Allocate 20 per cent to each. Hold this portfolio for at least five-seven years. Rebalance whenever there is a deviation by plus or minus 5 per cent from original allocation,” says Kumar. This approach, he says, can smoothen an investor’s journey as two or three of the five strategies would hold up the portfolio at any point.

 

Satellite portfolio approach

 

Alternatively, build your core portfolio with market cap-based passive funds (allocate 40–60 per cent to it). Allocate the rest to the satellite portfolio, picking one or two factor funds for it.

 

“Go for those styles of factor funds in which you have high conviction. This will make it easier to hold on to them during periods of underperformance,” says Raghaw. He recommends allocating 10–15 per cent of the equity portfolio to each factor fund.

 

Investors’ risk appetite can be another criterion. “Conservative investors may invest in a low-volatility style as it provides downside protection. Those with the appetite for higher volatility may invest in the momentum strategy, which has performed well over the long term,” says Goyal.

 

Avoid selecting factor funds based solely on past performance, as a winner in the recent past could be headed for a downturn.