Fund management is often consider in much higher regard than it really deserves. This is especially true of large-cap core equity funds. Most of these funds are ‘closet index funds’ . Which means their portfolio weights for stocks are fairly close to that in the benchmark equity indices.
And yet, in recent years, they have regularly underperformed their respective benchmarks – especially in the large-cap space. This begs the obvious question – is it possible for an investor to sidestep equity mutual funds entirely and take charge of his/her investments directly?
The short answer is, yes! Behold, factor investing! A mutual fund manager doesn’t really decide which stocks to buy as much as which stocks to be overweight and which others to be underweight. This comparison of overweight and underweight is vis-à-vis the benchmark. Given the competitive pressure to outperform the benchmark, fund managers start with the benchmark weights of stocks and then tweak these weights based on their judgment. This judgment – their core skill – is typically based on attributes of the companies such as valuation, management quality, profitability, growth, return on equity, governance, prospects of the sector etc.
Till recently, most fund managers had a certain halo around them. They are widely regarded as having mastered the art and science of investing. However, the steadily declining outperformance of equity funds has made most investors wonder if there is any real ‘art’ element to investing. The good news is that the ‘science’ element of investing can be used without all the hype of star fund managers and decade-long track records! This is where factor investing enters the picture. The idea behind factor investing is simple. A specific attribute of all companies in the investment universe can be used to rank them to build a portfolio. All that an investor needs to do is be overweight in the high-ranking stocks and underweight in low-ranking stocks. In other words, replicate the investing principles used by fund managers but without all the costs and noise.
What is a factor?
Most well-recognized examples of factors are value, quality, growth, profitability, volatility and momentum. Lot of things define about value over the years, including by veterans like Charlie Munger. It is essentially having the stock price to earnings ratio lower than one’s peers (or low P/E). Book to price is also a value indicator. The growth factor is based on a suitable combination of earnings growth and revenue growth.
Quality has emerged as an important factor in recent years. It is a combination of capital efficiency (e.g. return on equity) and robustness of balance sheet (e.g. cash profits being in line with accounting profits). Volatility factor is based on the stability of corporate earnings as well as the stock price. Momentum factor refers to the long term upward trend in earnings growth and stock price. This was all about Mutual fund and factor investing.
Read more: Mutual Funds Sahi Nahi Hai