Factor premiums are risk-adjusted returns that have a strong economic or behavioral rationale. The most common factors are value, momentum, quality, low volatility and size. Factor investing is done by designing a portfolio of stocks using parameters representing a particular factor. For example, one may use high sales to price or high earnings to price among others to buy value stocks. Similarly, each factor is represented by particular parameters. The benefit of factor-based portfolio construction is that one can back-test these rules over a long period of time going back many decades.

This helps in analyzing the robustness of the factor over various macros and micro cycles. Traditional discretionary fund involves relying on the expertise of the fund manager in picking stocks. For many traditional funds, one has to rely on the past track record of the manager for evaluation. It is often challenging to find enough funds with long track records for this purpose. Factors on the other hand can be easily back-tested over a very long period. On the other hand, the benefits of traditional investment methods are that an experienced manager can use various qualitative information in their portfolio construction that cannot be easily used in a factor-based model. Factor-based and traditional discretionary investing are complementary to each other. Any investor should evaluate to have both as part of their allocation.

What makes momentum investing viable?

Momentum factor is categorized as a behavioral factor which is measured using the change in the price of a stock over a period of time. A momentum portfolio selects stocks with higher total returns compared to their peers. The rationale behind momentum is that this upward or downward trend, driven by market sentiment, would continue for some more time and can be used to generate returns. It is one of the most robust factors which has proven successful globally and also in Indian markets. Even though the factor generates very high returns, it is combined with large draw-downs in bearish markets. But the high risk-adjusted returns provide investors with a strategy that should provide great wealth-creation opportunities over a longer period. For investors who may not like the high volatility of the momentum portfolio, it can be combined with other factors such as quality or value to reduce the drawdown effects because of the low correlation between factors.

How important is Factor investing amid high inflation?

Factor investing has a long history of being used in professional fund management over many decades, especially in the US. Academic research and backtesting have shown it to have worked over a century of available data. Even though factors are affected by macro events such as inflation, it is important to note that their risk-adjusted premiums are robust over the medium to longer term. This is why even though macro events might affect the returns in the short term, the viability of factor investing has survived many such market cycles. Also, not all factors are affected by the same macro event, so a multi-factor approach is advisable in case one wants to reduce the cyclicality of an individual factor return.

How the consistency of Factors relates to the World of Investing?

Each of the factor premiums exists because of robust economic or behavioral rationale. This premium has been shown to persist over the medium to long term across multiple geographies. But each individual factor behaves differently in various market cycles which makes a single factor cyclical in nature over the short term. The persistence of risk-adjusted return from factor investing has been proven to work across a long period not only through academic research and backtesting through historical data, but also through the robust live performance of factor-based funds globally and in India. Consistent and patient investment in factor based strategies has shown to be a great way of long term wealth creation. The rule based approach has the added advantage of providing transparency in the stock selection process and explanation for the return attribution of a portfolio which has been one of the biggest reasons for its success at both institutional and retail levels globally and increasing domestically as well.

Multi-Factor Investing

In cricket, the team’s overall composition frequently matters more than any one star player. And just like different players in the cricket team tend to have different phases of performance, individual factors can undergo prolonged underperformance with impatient investors running out of patience before reaping their benefits. Just as a team combines the individual strengths of its players, a multi-factor strategy has the potential to overcome the cyclicality of the factors combined.

A successful team in cricket is often about the composition of the team rather than the individual star player.

The relationship between single factor and multi-factor strategies is no different in this regard – the team is the combination of the individual factors into one multi-factor strategy. A factor can undergo prolonged periods of underperformance with disillusioned investors running out of patience before the benefit of exposure to that factor is reaped.

There is no right or wrong answer as to how many and which factors to include in a strategy, but all the benefits of diversification apply to factor investing as well. A multi-factor approach can offer diversification and smoothen the ride through the investment journey by harvesting multiple sources of returns.

The challenge of a multi-factor portfolio is to decide how many factors to include and what approach to take. The answers can be easily found in the investor preference and objectives themselves. Investors who prioritize returns over costs may prefer a portfolio strategy dominated by momentum, while those with a strong preference for stable, consistent returns may consider low volatility to be the foundation of their portfolio. When designing a strategy for an astute investor segment with higher risk tolerance, one may consider concentrated single factor strategies to be appropriate. On the other hand, when designing a strategy for a wide variety of investors, a multi-factor strategy may serve the purpose best.

• Source: NJ research, Bloomberg, National Stock Exchange
• Calculations are for the period Oct 2002 to Aug 2022.

• Source: NJ research, Bloomberg, National Stock Exchange
• Calculations are for the period Oct 2002 to Aug 2022.

• Source: NJ research, Bloomberg, National Stock Exchange
• 10-Yr CAGRs are calculated for the period 30 September 2002 to 31st August 2022 and have been rolled on a daily basis.

How multi- factor strategy can help in your portfolio construction?

Single factors as explained above, have high risk-adjusted returns along with higher volatility and cyclicality in their returns due to various macro business cycles. But the various factors also have a low correlation to each other given the diversity in the rationale for the persistence of their premiums. This low correlation provides the benefits of diversification when two or more factors are combined to achieve a much smoother risk-adjusted return, say for example by combining quality, value, low volatility and momentum. Factor strategy returns have shown to perform better than the market benchmark over the medium to longer term and should be an important wealth creation allocation for any investor.

What does “Blue-chip” denote and why such companies are preferred for Investment?

Companies with high and sustainable competitive advantages that protect their market share and profitability possess high MOAT and are referred to as “Blue-chip” or “Quality” companies.

Some names with which Indian stock market associates the notion of “Quality” are Asian Paints Ltd, Nestle Limited, Britannia Ltd, Hindustan Unilever ltd, Pidilite Industries, Bajaj Finance, HDFC Bank, Titan etc.

Fundamentally these companies have shown consistent Cashflow growth over the last 10-15 years. In terms of stock market performance, these “Quality companies” in times of market expansion have either yielded similar market returns or more and during consolidation these companies have fallen lesser than the market (assuming Nifty returns for illustrating market returns). In the last 10-15 years, the superior performances of these companies have been witnessed multiple times and hence the return matrix of these companies have imprinted on investors’ mind thus making them Investor favorites.

Under Performance by Quality Companies in Recent Times

In the recent times, post Covid lows in Mar 2020, there is a strange change of behavior of these quality companies price movement vis a vis market movement. The superior performance of quality companies that seemed as a rule of the market has been overruled by the markets. In the rally from Mar 2020 lows to Oct 2021 highs, these companies delivered more or less market returns however, during the decline from Oct 2021 highs to Jun 2022 lows, these companies have fallen “more” than the market unlike what was witnessed in earlier expansion and consolidation phases of the market.

Table of Returns for Quality Nifty Companies during Oct 2021 to Jun 2022

Factors Attributed to Quality Companies Recent Underperformance

Our studies show that this inferior performance has more to do with the investment opportunity becoming wider than before in Indian context. In times of benign corporate profit growth during the last 10 years, these companies continued exhibiting consistently high cash flow growth which kept shifting their valuation range to higher and higher trajectories. Going forward, a broad based earnings growth is expected from all sectors like Banking, IT, Pharma, Industrials, Energy, Discretionary etc. This has resulted in Valuation range of the favored stocks coming down one notch lower to 2016-2020 levels.

Some Examples of Quality Companies’ Valuation Re-basing

Is Quality Out of Fashion Now?

We believe the valuation range for Quality companies are settling by the process of mean reversion. In many stocks the reset has been already done while in some the process is still continuing. Quality is here to be. There are many opportunities in good quality companies that Investors have waited for years for making an entry. This era has to be utilized for the same. We assume, companies will rebase itself to previous valuation range and then react to earnings and cash flow for the new trajectory for prices. We have seen over a long term period, companies with high cash flow and sustainable high return ratios reward stock market investors.

Hence, the faith on quality stocks is maintained and this price correction is assumed to be a part of adjustment to normalcy. In the long term, Investors make money if they are associated to good quality companies and management. So, for some time these companies may go out of fashion, but for long term investment in “Quality is Forever.”

What is Asset Allocation?

Asset allocation means spreading your investments across various asset classes. Broadly speaking, that means a mix of stocks, bonds, and cash or money market securities.

The goal of allocating your assets is to minimize risk while meeting the level of return you expect. To achieve that goal, you need to know the risk-return characteristics of the various asset classes.

The figure below compares the risk and potential return of some of them:

Because each asset class has its own level of return and risk, investors should consider their risk tolerance, investment objectives, time horizon, and available money to invest as the basis for their asset composition. All of this is important as investors look to create their optimal portfolio.

Investors with a long time horizon and larger sums to invest may feel comfortable with high-risk, high-return options. Investors with smaller sums and shorter time spans may prefer low-risk, low-return allocations. The rule of thumb is that an investor should gradually reduce risk exposure over the years in order to reach retirement with a reasonable amount of money stashed in safe investments. This is why diversification through asset allocation is important

To make the asset allocation process easier for clients, many investment companies create a series of model portfolios, each comprised of different proportions of asset classes. Each portfolio satisfies a particular level of investor risk tolerance. In general, these model portfolios range from conservative to very aggressive.

Strategies for Asset Allocation based on Debt/Equity Proportion

A Conservative Portfolio

The main goal of a conservative portfolio is to protect the principal value of your portfolio. That’s why these models are often referred to as capital preservation portfolios. Even if you are very conservative and are tempted to avoid the stock market entirely, some exposure to stocks can help offset inflation. You can invest the equity portion in high-quality blue-chip companies or an index fund.

A Moderately Conservative Portfolio

A moderately conservative portfolio works for the investor who wishes to preserve most of the portfolio’s total value but is willing to take on some risk for inflation protection. A common strategy within this risk level is called current income. With this strategy, you choose securities that pay a high level of dividends or coupon payments.

A Moderately Aggressive Portfolio

Moderately aggressive model portfolios are often referred to as balanced portfolios because the asset composition is divided almost equally between fixed-income securities and equities. The balance is between growth and income. Because moderately aggressive portfolios have a higher level of risk than conservative portfolios, this strategy is best for investors with a longer time horizon (generally more than five years) and a medium level of risk tolerance.

An Aggressive Portfolio

Aggressive portfolios mainly consist of equities, so their value can fluctuate widely from day to day. If you have an aggressive portfolio, your main goal is to achieve long-term growth of capital. The strategy of an aggressive portfolio is often called a capital growth strategy. To provide diversification, investors with aggressive portfolios usually add some fixed-income securities.

A Very Aggressive Portfolio

Very aggressive portfolios consist almost entirely of stocks. With a very aggressive portfolio, your goal is strong capital growth over a long-time horizon. Because these portfolios carry considerable risk, the value of the portfolio will vary widely in the short term.

Maintaining Your Portfolio

As you decide how to allocate your portfolio, you might choose one of several basic allocation strategies. Each offers a different approach based on the investor’s time frame, goals, and risk tolerance.

When your portfolio is up, it’s important to conduct a periodic review. That includes a consideration of how your life and your financial needs have changed. Consider whether it’s time to change the weighting of your assets.

Even if your priorities haven’t changed, you may find that your portfolio needs to be rebalanced. That is, if a moderately aggressive portfolio racked up a lot of gains from stocks recently, you might move some of that profit into safer money market investments.

The Bottom Line

Asset allocation is a fundamental investing principle that helps investors maximize profits while minimizing risk. The different asset allocation strategies described above cover a wide range of investment styles, accommodating varying risk tolerance, time frames, and goals.

When you’ve chosen an asset allocation strategy that’s right for you, remember to review your portfolio periodically to ensure that you’re maintaining your intended allocation and are still on track for your long-term investment goals.

Concluding View

We apply air bags, disc brakes or EBD to a racer car. These features will enhance the confidence of a driver to drive the car at a high speed but with good confidence to control the car.

In a same way, intention of doing Asset allocation & its periodic review is to minimize the investment portfolio risk. It is never intended to enhance the returns. Investor and advisor must be very clear of its possible outcomes when you opt for Asset allocation strategy.

No Asset allocation strategy can be a winner (best return generator) in all market conditions. It will allow intended risk/return experience during the journey of an investment.

Every person has some financial goals like retirement, medical plan, child’s education, travelling, getting a new house, car, etc. Please refer to the below image:

As can be seen above, every individual has limited earning life (Phase II) and has financial goals to achieve from birth till the end of life.

Every person has a surplus income during his/her earning life and looks for investment options where he/she can park his money.

Among various investment options, Fixed Income options were the most popular ones in the last 50 years. FD, Bonds, Debentures, LIC, PPF or Post Office saving schemes are a part of the Fixed Income asset class. Capital protection and Fixed Income is the most loved feature enjoyed by most Indian investors till now.

Post Liberalization of the Indian economy in 1991, things started changing. After 1991, the Economy which was in the doldrums started to take baby steps. The speed of improvement was slow from 1991 till 2003. Post that liberalization started showing its results and the Indian economy started showing visible improvements. The effect of this was a significant reduction in Interest rate. On one hand it helped many Indian entrepreneurs to raise cheap capital for their ventures, but on the other hand reduced Fixed Interest to the Savers.

India’s long term Inflation average is around 6.5%. We know that each asset class returns must beat Inflation in order to remain attractive in a long run. As can be seen in the image below, post 2003 the Fixed Interest returns diminished and started kissing the inflation or lately now have even started to even underperform. Long term returns of different investment avenues above the dotted line of average inflation can be observed below.

In the situation where most loved Fixed Income products started underperforming Inflation for a long time, the Investors had no option but to look for other investment classes at the cost of increased risk. Gold & Real Estate offered a small overperformance over Inflation.

Gold & Real Estate offered a small over performance over Inflation. But at the same time had some disadvantages such as low liquidity, physical nature & a large ticket size with storage or maintenance cost.

Equity / Stock Markets, on the other hand, had a significant overperformance compared to Inflation but it is a very volatile asset class as per the popular perception of a common man. We can see the typical returns below:

On a closer look & data crunching, the Equity asset class in the short term looked to be extremely volatile & unreliable, was not that volatile or unreliable in horizons of 5 years or above. So, investors who were ready to park their surplus funds for a long term started understanding this asset class.

Also, the introduction of managed products in the Equity asset class such as Mutual Funds or PMS during the period 1996 to 2000 allowed an entry of common investors to park their surplus money. By 2010, many investors and analysts had understood that Mutual Funds were a less volatile & professionally managed version of Equity investment that gave significantly higher returns compared to all other asset classes in the long run.

Investors realized and adjusted to the nature of equity over some time. They realized that equity has the following features:

• Equity can significantly beat Inflation in the long term
• Equity provides higher liquidity compared to most other asset class
• Equity is the most efficient asset class in India

But it also must be taken into consideration that:

• Different asset classes Outperform / Underperform each other in different market cycles.
• .Investors also have requirements for their surplus in the short term

The above facts also warrant that a proper Asset Allocation is required when it comes to parking your total investible surplus. The following must be considered while doing Asset Allocation:

• Risks & Rewards are interrelated i.e. Higher returns, higher the risk
• Asset Allocation protects from the vagaries of the market
• Situations in life can be unpredictable and liquidity is extremely important
• Asset allocation is different for different person

Portfolio adjustment as per risk bearing capability

Younger people who have time for an investment to grow and compound should have a major portion of their portfolio in equities (say 60-65%). While risk-averse and elder Investors should have more of debt, liquid assets and lesser equity (less than 30%) in their portfolio.

Key Takeaways

• Invest in equity to gain higher returns.
• Stay invested in equity for a longer period.
• For short term investments, prefer FDs, Bonds and Liquid assets.
• The portfolio should be well-diversified and at the same time have assets that can meet financial goals.
• Equity investment should also consider the risk-taking ability of the investor.