Are factor funds the future of investing or just a risky trend?

Fund houses are increasingly launching factor-based strategies as they expand their product suite even as quant strategies gain acceptance from investors.

WHAT ARE FACTOR FUNDS?

Factor funds are a type of investment fund that use specific and measurable characteristics, or factors, to select stocks while building the portfolio. The aim is to enhance returns and manage risk in a systematic way. These schemes use factors like value, quality, momentum, and low volatility to create a portfolio of stocks based on pre-defined rules, rather than simply tracking market-cap indices like the Nifty 50 or Nifty Next 50.

WHAT TYPES OF FACTOR FUNDS ARE AVAILABLE?
Indian investors have access to a mix of active and passive factor funds based on factors such as value, momentum, quality, and low volatility. There are several schemes built around these strategies, such as the Nifty 200 Momentum 30, Nifty 100 Quality 30, and Nifty 50 Value 20. Some fund houses also offer active multi-factor strategies and active strategies around individual factors. These funds are slowly gaining popularity among wealthy investors and family offices, with retail investors also beginning to participate. The most popular factor funds currently are those based on the momentum strategy.

HOW ARE FACTOR FUNDS DIFFERENT FROM TRADITIONAL ACTIVELY MANAGED OR PASSIVE FUNDS?
Active funds rely on a fund manager’s discretion to build a stock portfolio, while passive funds simply mimic an index. Factor funds, by contrast, use pre-defined investment rules based on a number of factors or characteristics. For example, a fund may start with a market-cap index like the Nifty 200, apply a momentum filter, and build a portfolio of about 30 stocks.

WHAT ARE THE BENEFITS AND DISADVANTAGES OF FACTOR INVESTING?
Financial planners believe investors should diversify their equity portfolios to reduce risk. Factor-based investing helps achieve this by diversifying equity exposure and reducing fund manager bias. Each factor tends to respond differently to various economic cycles. Combining multiple factors can help spread risk across a portfolio. However, factor funds often have higher expense ratios than traditional index funds because they require more active management, research, and analysis to identify and select stocks based on the chosen factors. They can also be vulnerable to shifts in market conditions. Certain factors, such as value or momentum, may perform well during specific market cycles but struggle during others—for instance, value stocks might underperform during growth periods, while momentum stocks may lag in a stagnant market. As a result, factor funds are subject to market cycles and may not always deliver consistent returns