Factor Olympics 1H, 2024, a report by UK-based Finominal, suggests that there’s no pattern or consistency to when a given factor will outperform. If there is one take-away from this research update, then it should be that factors are cyclical

Investing is mostly about exploring, exploiting and experiencing. While it’s difficult to always outperform the markets, it’s relatively easy to achieve the benchmark returns by just sticking to or tracking the benchmark. By investing in the benchmark or the index, one could achieve near market returns at lower costs and effort. As investors, our endeavor is to generate better returns, better than the benchmark, better than the market, etc.

So, we’ve so many market strategies, each one successful but go through phases of underperformance. This is not completely due to the flaw in the strategy but just that it doesn’t fit to the prevailing markets. When our employed strategy works, we try to extrapolate that across the market conditions and find that it might not be effective all the time. The eureka moment at each solution found to an existing problem is short-lived as the market circumstances change and hence newer solutions required for those set of problems. And as we exploit a solution, the market behavior is altered rendering the solution to be redundant.

Factors are one such strategy that was considered panacea of all investing, the latest research suggest otherwise. In its latest post, Finominal, a UK based research analytics firm in its bi-annual review of the factors, Factor Olympics 1H, 2024 report had come up with some interesting insights. The report suggests that there’s no pattern or consistency to when a given factor will outperform. If there is one take-away from this research update, then it should be that factors are cyclical as that is the prevalent theme of the first half of 2024. Factors are nothing but some common attributes which could drive or create value to the investment strategy. Factor investing revolves around identifying these determinants ranging from macroeconomic to fundamental to statistical, that could have correlation to the outcomes, employ them to achieve the desired results. The usual and popular factors include capitalization based (large/mid/small, etc.) to style based (growth, value, etc.) volatility based (momentum, low volatile, etc.) and even credit rating (in bonds, debt, etc.)

While everyone strives to achieve better returns, the use of factors or quants predisposes the decision-making process by reducing if not eliminating the human biases or errors. The various investment calls would be filtered through a process stipulated by these factors which in turn derive the list that would be played upon. This streamlines the criterion for the selection of securities thus narrowing the options to act upon to a pre-defined strategy. The whole effort is to avoid the human error or judgments that could be subjective to humans through their biases.

A factor-based investment strategy sticks or only picks on to the defined parameters and wouldn’t stray away from it thus paving way for an objective decision making. Over the years, dozens of purported factors have been identified but instead of considering all, a few of the relevant ones are zeroed on. The requirements of any factor are performance, proof, persistence, explainable and executability. On this filtration, the common equity factors derived viz., value, size, momentum, quality and low volatility. There are a few morelike dividend yield and income.

For instance, the performance of US S&P 500 was done by the heavy lifting of tech stocks which hogged much of the proportion of the weight in the index. The factors that worked better during this phase of the market seem to be of momentum. Even here the top ten weights have been from the tech industry, accumulating to over 65 percent. Though, one ended up with a higher outperformance particularly in the last few quarters, one should be aware of the additional risk. Is the extra risk worth the incremental returns is what needs to be looked at. Not deriding the factor investing from the report, one should be aware of the pitfalls of blindly sticking to a particular strategy. The market is very dynamic and hence a diversified portfolio with a flexible mandate always achieves better risk adjusted returns to the investor.

(The author is a partner with WealocityAnalytics, a SEBI registered Research Analyst and could be reached)