No one factor works well all the time! So it makes sense to have multiple factors in the same portfolio.
Wright Research’s Multi-Factor portfolios were the first portfolios we started with three years ago, and they have had a fantastic run. In this post, we want to cover the salient points of the multi-factor approach.
What are the Factors?
“Factors” and Factor Investing are getting increasingly popular in the Indian market. A “Factor” is a differentiating characteristic of a stock that delivers excess returns. These factors are deep-rooted rationales for outperformance that have lasted over decades.
While “factor investing” usually requires a lot of data and numbers, factors are very intuitive to understand for a regular investor.
Factor investing strategies are typically created as a basket of stocks. However, as quantitative methods are used in making these strategies, the baskets are very well diversified and, more often than not, carry a risk less than the Nifty index!
Factor strategies can be a game-changer for long-term performance. While the Nifty 50 Index has given around 10% CAGR since 2010, most factor strategies have a much higher return. There is no one set definition of a factor or its methodology, but based on different interpretations, a range can be set for the factor returns based on data from 2010. Because India has been a growth market in the last decade with significant bull markets, the best performing factor in India has been Momentum or Trend Following. Momentum is followed closely by Growth and Quality factors. The Low Volatility factor gives good performance at extremely low risk, while Value also outperforms in the long term.
As the definition of factors can differ for different people, we have given a range of factor CAGRs here. The NIfty Factor Index returns fall within this range.
The Multi-Factor Approach
Now again, no one factor is the single solution. For example, in a bull market like 2021, Momentum has given astronomical returns while quality and value strategies have drastically underperformed in comparison. But as the correction started in Q4 202, Momentum has lagged while Value and Low Volatility have done much better.
You need at least ten factors to explain significant variance in market returns. Unfortunately, a single factor can only be a satellite portfolio because it only works in specific market regimes.
To use the power of factors, a much more innovative approach is multi-factor investing, which simply means a portfolio that combines multiple factors. When you combine various factors, you get an added advantage from diversification because the factors do not move together. By definition, the factors are chosen such that the correlation between any two factors is less than 50%. Hence, if one factor goes down in a multi-factor portfolio, the other factor would support the portfolio. Thus a multi-factor portfolio would give you an exceptional performance due to the constituent factors, but the risks would become drastically lower.
How to combine factors
There are many ways of combining factors and several interpretations. Some people just choose their preferred factors and give them equal or set weights to do tactical allocation to factors. This means that depending on the market conditions, they shift their allocation to factors. For example, in a trending market like 2021, we allocate more to momentum, but as the volatility creeps in, we shift to more quality and value allocation. We even include some bonds and gold ETFs along with the factors to allocate to in times of extreme volatility.
Expectations of Multi-Factor Investing
Let’s look at the stats to understand the utility of multi-factor strategies. This is quite open for interpretation and highly subjective, but a multifactor approach can give you more than 20% CAGR based on an analysis of more than ten years of data wherein the multi-factor approach mentioned here is dynamic where factor weights vary based on market conditions and while the multi-factor strategy might lag a momentum strategy in terms of returns, the multi-factor approach has a much lower risk and excellent risk-adjusted return, making it ideal to become the core of someone’s portfolio.
Wright Multi-Factor Performance
With a 30% CAGR in 3 years and at a risk much lower than the index, we have done true to our potential.
The Bottom Line
The bottom line is that factor investing is not only a fascinating area of research if you are a math and investing nerd, but they are also a fantastic way to generate a better-than-market return at a very conservative risk. These strategies depend on numbers- whether technical or fundamental- and your results will depend on the quality of your data.
The performance depends on the portfolio creator, but simple tools like diversification, risk targeting, and dynamic deallocation can make these strategies extremely safe. While some factors like momentum are excellent ways to take advantage of the bull market, a multi-factor approach can be a perfect way to compound your way to 10X in 10 years at a risk which is much better than the market.
How to Invest?
Looking to invest in the infamous Multi-Factor portfolio? Check out our smallcase!