Factor Investing
Factor investing is an investment approach that targets specific, academically documented characteristics — known as factors — that have historically explained a significant portion of asset return differences, including style factors such as value, momentum, quality, size, and low volatility.
Factor investing emerged as the empirical successor to CAPM, motivated by the observation that beta alone failed to explain the full cross-section of asset returns. Academic research by Fama and French in the 1990s documented that small-cap stocks (size factor) and cheap stocks (value factor) delivered returns above what CAPM predicted, even after accounting for their market beta. Subsequent research added momentum (stocks that had risen recently tended to continue rising in the short term), quality (profitable, conservatively managed companies outperformed), and low volatility (lower-risk stocks outperformed on a risk-adjusted basis) to the roster of investable factors.
In India, Nifty India Limited (NSE Indices) launched a suite of factor indices — Nifty 50 Value 20, Nifty Quality Low-Volatility 30, Nifty Momentum 50, Nifty Alpha 50, and multi-factor indices — that provided the basis for passive factor ETFs. SEBI's categorisation framework introduced a dedicated "Thematic/Factor Funds" category, enabling mutual fund houses to launch products explicitly tracking factor indices. As of 2024, funds tracking value, momentum, and quality factors had accumulated several thousand crores in AUM, reflecting growing retail and institutional interest in factor-based strategies.
The value factor captured the premium associated with stocks trading at low multiples of earnings, book value, or cash flows. Academic evidence suggested that investor overreaction — paying too much for glamour growth stocks and too little for out-of-favour value stocks — created a persistent mispricing that mean-reverted over time, generating the value premium. In India, value investing had deep roots through the influence of Warren Buffett's philosophy and the track records of value-oriented fund managers like those at HDFC Mutual Fund and Quantum Mutual Fund.
Momentum was perhaps the most counterintuitive factor: buying recent winners and avoiding recent losers. The behavioural explanation centred on investor underreaction — prices adjusted to new information too slowly, causing trends to persist in the near term. Indian momentum indices like Nifty Momentum 50 had shown strong historical performance, though with pronounced cyclicality: momentum strategies performed extremely well in trending markets and suffered sharp drawdowns during mean-reversion episodes.
Factor premiums were not guaranteed to persist in all periods and required long investment horizons to capture reliably. Factors experienced extended periods of underperformance that tested investor patience — the value factor, for instance, underperformed significantly through the 2010s globally. In India, factor investing's growing mainstream acceptance through SEBI-regulated passive products made it accessible to a broader investor base while also increasing the theoretical risk that widespread adoption could erode factor premiums over time — a philosophical debate that remained active in the quantitative investment community.