With most mutual funds (MFs) completing their bouquet of active fund products, they are now exploring the smart beta or factor-investing space to create differentiated products. This is evident from the sharp surge in factor-based indices in recent years.
The National Stock Exchange (NSE) has 31 factor-based indices, up from 23 at the start of 2024. Exchanges mostly create new indices based on demand from MFs.
There are now close to 80 index funds and exchange traded funds (ETFs) tracking these indices and some of BSE. Majority of these funds have been launched in the last two years.
The growing traction for factor funds is not just limited to index funds and ETFs. Fund houses are also increasingly exploring the active route as well. While active value funds have been present for some years now, few active momentum funds have come up in the last two years. Two active quality funds are lined up for next year too.
Then there are also fund houses that use factor-based strategies in their regular active funds.
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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.
Radhika Gupta, managing director (MD) & chief executive officer (CEO), Edelweiss MF said the fund house found the approach more suitable as compared to fundamental investing in the case of some of its offerings.
“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,” she said.
NJ Mutual Fund manages 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.
Active funds are generally managed through a fundamental-based approach, wherein the fund manager takes the call on stock selection based on the company’s fundamentals. However, even fund managers are known to have style bias with some managers giving higher weightings to valuations, while others scout for companies with higher growth potential.
In addition, most of the quantitative funds in the market are also primarily based on factors.
For example, the recently launched SBI Quant Fund will allocate its corpus across the four ‘style’ baskets, which are momentum, value, quality, and growth. The fund aims to increase and decrease the weightings of the four factors depending on their performance.
MF industry executives believe that the demand for these products will pick up over time, depending on investor awareness and the performance of these schemes.
“Factor investing has been gaining traction globally, and India is no exception. As more investors become aware of the benefits of factor investing, such as diversification and potential for enhanced returns, the adoption rate is expected to rise,” said Karthik Kumar, fund manager, Axis Mutual Fund.
According to Aashish Somaiyaa, CEO at WhiteOak Capital AMC, the recent investor experience in the market has created some demand for such products.
“In the last five years there has been violent rotation in growth vs value and large cap vs mid and small cap for instance. This has made people realise how much of a difference a factor at play can make. Hence, they have started to believe that they should buy factor based funds and that they can predict which factor will dominate next,” he said.
WhiteOak Capital MF is set to launch an active quality fund in January 2025.
“The choice of quality as a theme is a result of our belief in fundamental investing in select spaces of the market rather than necessarily forecasting it as the next factor at play in the markets. Factors keep rotating with macros but ultimately businesses with the above attributes will reward investors,” he said. This segment of the market, which falls between the active and passive space, has also provided the scope for fund houses to stand out. The smart beta space allows creation of differentiated offerings as opposed to the plain vanilla passive space.
“Till now, our entire fund bouquet comprises only active funds that follow a fundamental based investing approach. One of the reasons is that passive space has no space for differentiation,” Madhu Nair, CEO of Union AMC.
The fund house recently launched an active momentum fund, its first in the factor investing space.
“We took the factor-based approach as we wanted to differentiate,” he said.
Factor funds in investor portfolios
According to MF officials and analysts, investors can look at these schemes depending on their needs and understanding of the product.
“These funds provide investors with the flexibility to tailor their investment strategies according to specific market segments or themes, offering the potential for enhanced returns and better risk management. By carefully selecting and combining different Smart Beta strategies, investors can create a diversified portfolio that may outperform traditional broad market indices under various market conditions,” Nippon India AMC said in a recent release.
Jiral Mehta, senior research analyst at FundsIndia, said that while there are numerous options in this space, her preference lies with actively managed funds.
“Factor funds that are based on specific factors such as momentum, value, volatility, growth, quality have worked persistently and across different equity markets. You can play this strategy through a rule-based fund (for example quant funds, smart beta funds etc.) or an active fund where the fund manager can use qualitative judgment,” Jiral said.
“We prefer actively managed established funds instead of passive funds since the stocks are carefully chosen by a fund manager considering the qualitative nuances of these factors. In rule-based funds as the index constituents are selected based on few specific metrics, stocks with weaker fundamentals and other corporate governance issues might also form part of the portfolio,” she added.
The demand among investors has also picked up on the back of strong performance of some of the factor-based strategies. In the largecap space, which has the most number of factor-based offerings, they have emerged as a strong competition for active funds. In the one-year return chart, funds like Nifty Alpha 50 and Nifty 200 Momentum 30 index funds and ETFs have been consistently ranking in the top quartile.
Factor-based investing
> It is an investment approach that targets specific drivers of return across asset classes. Factors are broad, persistent characteristics that drive a security's return. Common factors include value, momentum, quality, and volatility. Schemes using this strategy are also known as smart-beta funds
> Funds managed through the factor-based approach select stocks on the basis of select characteristics. A momentum fund, as the name suggests, picks stocks that have recently shown strong upward momentum. Value funds focus on relative valuations, while quality funds look for companies that have strong balance sheets, stable earnings and high return on invested capital
> There are also multi-factor funds which take two or more factors into account to enhance returns or lower volatility. In the last two years, several multi-factor passive funds have hit the market. Nifty Alpha Low Volatility 30, Nifty Smallcap 250 Momentum Quality 100, Nifty500 Multicap Momentum Quality 50 are some of them
> As passive investing gains popularity, smart beta strategies have emerged as a bridge between traditional passive funds and active management, offering a more tailored approach to capturing market inefficiencies,’ said Nippon India MF in a recent report
> One of the advantages of factor-based investing, according to experts, is the potential to improve risk-adjusted returns, while also creating more options for portfolio diversification