Factor Investing in India: What is it and Why Should You Care?

What if building wealth wasn’t about chasing the latest stock tip, but about following patterns that have worked across decades and markets? That’s precisely what factor investing offers.

Rather than relying on hunches or market chatter, factor investing follows a data-driven, rule-based approach. It looks at specific attributes (or “factors”) that have been proven to influence returns and risk in the market, helping investors build portfolios with more consistency and less guesswork.

In India, this approach is gaining traction among both retail and institutional investors. By focusing on proven factors, investors can aim to boost performance and manage risk.

What is Factor Investing and Why Consider it?

In simple terms, factor investing is an investing strategy where you select stocks based on specific, measurable attributes (factors) that drive returns and risk. In essence, you define a rule (e.g., “buy the cheapest stocks” or “buy the stocks with healthy returns”) and build a diversified portfolio that shares those traits. This rule-based approach is sometimes called “smart beta” because it’s a smarter twist on index investing. It’s still passive and rule-driven, but not just following the market cap weight of an index.

Why consider factor investing? It offers the potential for better returns than the market by tapping into proven patterns, and it does so in a transparent, rule-based way. Over the long run, academic research (for instance, the Fama-French method) has identified certain factors that delivered extra returns beyond the market average. Factor investing brings those ideas from academia into a practical strategy for everyday investors. 

To know more about how factor investing works in the Indian markets, check out this video, where Robin Arya, Founder of GoalFi, breaks down how 3-factor and 4-factor indices are built, how they can help in bearish markets, and the role of rebalancing and exit strategies.

Common Factors Used in Investing

Not all stocks are the same; each has different traits. Researchers have found that certain factors tend to influence stock performance. Here are some of the most popular factors used in equity investing:

Value

The value factor focuses on how cheap or expensive a stock is relative to its fundamentals. Value investors look for companies that are solid but whose stock price is low relative to their true worth. In factor investing, a “value” portfolio might rank companies by ratios like price-to-earnings (P/E), price-to-book, or dividend yield, and pick the top tier of cheapest stocks. For instance, the Nifty50 Value 20 Index selects 20 blue-chip companies with low P/E, low P/B, and high dividend yield from the Nifty 50.

Momentum

Momentum is the idea of “buying winners.” A momentum portfolio typically looks at recent price performance (like 6-month or 12-month returns) and picks the stocks with the strongest momentum. For example, the NIFTY 200 Momentum 30 Index selects 30 companies from the Nifty 200 with the highest price momentum (measured by 6- and 12-month returns adjusted for volatility). Momentum strategies tend to be more volatile and require regular rebalancing (to catch new leaders and drop those that lose steam).

Quality

Quality is about buying fundamentally strong companies. While “quality” can be defined in different ways, it usually means companies with high profitability, low debt, stable earnings, and good corporate health. For example, the Nifty200 Quality 30 Index picks 30 companies with the best quality scores (based on ROE, low leverage, and earnings growth consistency). This factor gained popularity after the 2008 crisis, as investors saw that stronger balance sheets weathered the storm better.

Low Volatility

The low volatility factor is about reducing risk. It selects stocks that have historically shown lower price swings (volatility) than others. A low-volatility portfolio will pick the least volatile stocks (based on past price fluctuations) and often weight them so that the lowest volatility stocks get a higher weight. For example, the Nifty100 Low Volatility 30 Index takes 30 large-cap stocks with the most stable, low-variance returns.

Size

The size factor refers to company size. Historical data showed that small-cap stocks can outperform large-cap stocks in the long run. Size factor is more about favouring smaller companies (small- and mid-caps), which have historically delivered higher returns but come with higher risk.

Alpha

The alpha factor is a bit unique; it looks for stocks that have outperformed (shown high alpha) in the recent past, under the assumption that they may continue to outperform. Essentially, it’s capturing whatever isn’t explained by other factors, a measure of stock-specific advantage. For instance, the NIFTY Alpha 50 Index picks 50 stocks with the highest alpha (excess return) in one year. In practice, the alpha factor often ends up selecting dynamic, often mid-sized companies that have had strong runs.

Why Factor Investing Matters for Indian Investors

You might be thinking, “This sounds interesting, but why should I, as an Indian investor, care about factor investing when I already diversify enough?”. Here’s why:

1. Diversification beyond the usual stocks: In India, many actively managed mutual funds end up buying the same popular large-cap stocks. Factor investing offers a way out of that trap. By following a different rule-book for picking stocks, factor strategies often bring in a new set of companies that traditional funds overlook. 
2. A “smart” alternative: For years, Indian investors were largely presented with two choices: either pay high fees for actively managed funds (with no guarantee of outperformance) or settle for market returns with passive index funds. It combines the best of both worlds:

• Active pursuit of returns: Like active funds, it aims to beat the market by targeting specific drivers of return (factors).
• Passive implementation: Like index funds, it is rules-based, transparent, and typically more cost-effective than traditional active management.

3. Aligning with long-term financial goals: Investors are saving for long-term goals like retirement, children’s education, or property purchase. A quality-focused strategy invests in companies with strong balance sheets, stable earnings, and good corporate governance, basically, businesses that are built to last and compound wealth steadily over time. Similarly, a Value strategy encourages the discipline of buying good businesses at reasonable prices, a time-tested principle of long-term wealth creation.

4. Catering to your beliefs and strategy: Factor investing also allows personalisation. For example, if you strongly believe in India’s growth story, you might tilt toward the small size factor (more small/mid-caps). If you are a conservative investor, you might choose a low volatility strategy for relatively smoother rides. It’s a way to express an investment style systematically. 

5. Cyclicality and the case for multi-factor: As mentioned, each factor will have its ups and downs. This cyclicality is why many experts recommend a multi-factor approach for most investors. By combining factors, you increase the chance that at least one part of your portfolio is doing well at any given time. 

“No single factor works all the time – they each take turns leading and lagging. Combining multiple factors ensures that when one is struggling, another is thriving,” says Robin Arya, highlighting how a multi-factor portfolio can smooth out the ride.

The Rise of Factor-based Products in India

There’s been a rise of factor-based investment products, from indices to index funds, ETFs, and even model portfolios on fintech platforms. Here’s the current state:

NSE Factor Indices: The National Stock Exchange (NSE) has been busy launching a variety of factor indices (also called smart beta indices). As of 2024-end, NSE offered 31 factor-based equity indices, including single and multi-factor indices. These indices track all the factors we discussed.

ETFs and Index Funds: For nearly every major factor index, mutual fund houses have launched either an ETF or an index fund (or both) that tracks that index. By late 2024, there were close to 80 factor-based index funds/ETFs in India across NSE and BSE indices, including Momentum Funds, Value Funds, Quality Funds, and Multi-factor Funds, to name a few. 

Model Portfolios: Besides mutual funds, model portfolios have become a popular way to invest in factor strategies. These are offered on platforms like smallcase, where SEBI-registered professionals create baskets of stocks (model portfolios) that you can buy as a lot via your brokerage. 

The advantage of model portfolios on smallcase is that they can be actively rebalanced and managed strategies, and you get full transparency of the stocks you hold. They do come with a fee or subscription, but for beginners who want to follow a factor strategy with guidance, this can be a convenient route.

Other Products: A few PMS (portfolio management services) and robo-advisors also employ factor investing. This blurring of lines shows how influential factor investing has become.

To Wrap Up

In conclusion, factor investing in Indian stock markets is an exciting way for beginners to invest “smartly” by leveraging time-tested drivers of returns. It shifts the focus from hot tips and noise to a systematic strategy rooted in data. But that does not mean that any such methods are averse to market risks. As Robin Arya also puts it, “Money will never be made quickly in the market, no matter what anyone tells you. It will take its own time; the market will always charge you to teach you.”

Disclaimer: This analysis is for educational purposes and does not constitute investment advice. Market conditions can change, and past performance is not indicative of future results. Investors should conduct their own research and/or consult a certified financial advisor before making investment decisions.