Factor-based investing (a.k.a. smart beta) selects stocks by proven characteristics—like value, quality, momentum, size, low volatility, and dividends—to improve return, reduce risk, or both versus a plain cap-weighted index. This guide explains what factors are, why they work, and how Indian investors can use them prudently.
What Is Factor-Based Investing?
Factor-based investing tilts a portfolio toward systematic drivers of returns (“factors”) rather than simply owning companies in proportion to their market capitalisation. Instead of asking “Which stock will outperform?”, factor investing asks “Which traits have historically earned a premium?”
Common equity factors:
- Value: Cheaper stocks by P/E, P/B, or earnings yield.
- Quality: High and stable profitability, low leverage, good cash flows.
- Momentum: Stocks with strong recent performance (typically 6–12 months).
- Low Volatility: Lower historical price swings.
- Size: Smaller companies (often mid- and small-caps).
- Dividend Yield: Higher, sustainable payouts.
India has a growing ecosystem of smart beta indices and ETFs tracking these factors (e.g., value, momentum, quality, low-volatility, equal-weight). They offer a rules-based middle path between purely passive and fully active management.
Why Do Factors “Work”?
- Risk premia: Some factors (e.g., value, size) may reward investors for bearing specific risks—distress risk, illiquidity, or cyclicality.
- Behavioural biases: Momentum and value can arise from investor overreaction/underreaction, anchoring, or herding (see our article on Behavioural Finance).
- Structural constraints: Many institutions avoid certain segments (e.g., smaller or more volatile stocks), leaving persistent opportunities.
Reality check: Factor returns are cyclical. Each factor suffers multi-year underperformance at times. Success comes from diversification and discipline.
The Building Blocks (with Simple Metrics)
- Value
- Examples: low P/E, low P/B, high earnings yield.
- Quick metric:
Earnings Yield = EPS / Price = 1 / (P/E)
- Quality
- Examples: high ROE, low Debt/Equity, low accruals, stable margins.
- Quick metric:
ROE = Net Profit / Shareholders’ Equity
- Momentum
- Common definition: past 12-month return excluding the most recent month.
12–1 Momentum = Price(t−1) / Price(t−12) − 1
- Low Volatility
- Uses trailing standard deviation (σ) of returns; lower is preferable.
σ = stddev(daily or weekly returns)
- Size
- Smaller market-cap segments can deliver a premium over long horizons.
- Dividend Yield
- Dividend Yield = Dividend per share / Price per share
How Smart Beta Differs from a Nifty/Sensex Index
| Feature | Cap-Weighted Index (e.g., Nifty 50) | Factor Index / Smart Beta |
| Stock Weights | By free-float market cap | By rules tied to factor scores |
| Goal | Track market | Improve return/risk profile |
| Costs | Very low | Low-to-moderate (still lower than active funds) |
| Risks | Market risk, sector concentration | Tracking error, factor cycles, methodology risk |
| Rebalance | Periodic (semi-annual/annual) | Typically more frequent (quarterly/ semi-annual) |
Tracking Error (TE): how much a factor fund deviates from its broad benchmark.
Information Ratio = (Fund Return − Benchmark Return) / TE
How to Use Factors in an Indian Portfolio
1) Core–Satellite Framework
- Core: Broad, low-cost exposure (e.g., Nifty 50/500 index fund).
- Satellite: 10–30% allocation spread across 2–3 complementary factors (e.g., Quality + Momentum + Low Vol).
2) Choose Complementary Factors
- Diversify by behaviour:
- Quality/Low Vol tend to cushion drawdowns.
- Value/Momentum aim to enhance long-run returns.
- Reduce overlap: Combine factors with low correlation (e.g., Momentum with Low Vol/Quality).
3) Evaluate the Product (ETF/Index Fund) Before You Buy
A quick due-diligence checklist:
- Index Methodology: Definitions, scoring, and rebalancing frequency.
- Liquidity: ETF average daily turnover, market depth, and impact cost.
- Tracking Difference & TE: Realised under/overperformance vs index; stability over time.
- Expense Ratio: Low costs compound into better long-term outcomes.
- Portfolio Construction: Number of stocks, weight caps, sector limits.
- Rebalance Turnover: High turnover can raise costs and taxes.
- AUM & Longevity: Prefer sufficient AUM and established track record.
- Tax Treatment: Most domestic equity factor funds are equity-oriented for tax (STCG 15% if < 12 months; LTCG 10% above ₹1 lakh, currently). Confirm before investing.
4) Practical Allocation Example (Illustrative)
- Investor profile: Moderate risk, 10+ year horizon.
- Allocation:
- 70% Core: Nifty 500 index fund
- 10% Quality factor ETF
- 10% Momentum factor ETF
- 10% Low Volatility factor ETF
- Rebalance: Annually or when any sleeve deviates by >25% of its target weight.
Measuring Success (Keep It Simple)
- CAGR:
CAGR=(Ending ValueBeginning Value)1/n−1\text{CAGR} = \left(\frac{\text{Ending Value}}{\text{Beginning Value}}\right)^{1/n} – 1
- Risk (Volatility): standard deviation of monthly returns × √12.
- Sharpe Ratio:
Sharpe=Rp−Rfσp\text{Sharpe} = \frac{R_p – R_f}{\sigma_p}
- Max Drawdown (MDD): largest peak-to-trough fall in NAV.
- Information Ratio (vs core index): see above.
Tip: Judge factor funds across full market cycles, not single years.
Common Pitfalls to Avoid
- Chasing recent winners: Momentum works in rules, not as a performance-chasing habit.
- Ignoring costs and slippage: A factor with 2% expected edge can be nullified by high expenses and impact costs.
- Single-factor concentration: Increases drawdown risk when that factor underperforms.
- Strategy drift: Check that the fund continues to follow the stated index methodology.
- Tax churn: Frequent switching defeats compounding.
DIY Factor Tilt (For Advanced Investors)
If you screen stocks yourself (long-term, low-churn approach), consider a simple multi-factor score:
- Standardise each metric into a z-score (e.g., cheaper P/B = higher score; higher ROE = higher score; lower σ = higher score).
- Composite Score = Average of Z-scores (Value + Quality + Low Vol).
- Select top 30–50 from the Nifty 500 universe, apply 5% max per stock, and rebalance semi-annually.
Caution: Direct DIY comes with execution, tax, and behavioural risks; many investors may prefer regulated smart beta ETFs.
When to Expect Underperformance (and What to Do)
- Value may lag in growth-led, liquidity-rich bull markets.
- Momentum can whipsaw around sharp reversals (e.g., post-selloff rebounds).
- Low Volatility may trail in strong risk-on phases.
- Quality can underperform in speculative rallies.
Action plan: Pre-commit to allocation bands, use periodic rebalancing, and review process, not noise. Factor investing rewards patience and diversification.
Suggested visuals:
- Radar chart comparing factor profiles (volatility, drawdown, return).
- Rolling 3-year excess return chart: Factor ETF vs Nifty 500.
- Heatmap of factor correlations.
- Flowchart: “How to Pick a Factor ETF” (Methodology → Costs → Liquidity → Tracking).
Quick FAQs
Q1. Is smart beta passive or active?
Rules-based and indexed (so “passive” in implementation), but active in intention because it deviates from market-cap weights.
Q2. Are factor funds suitable for SIPs?
Yes. SIPs help average into factor cycles and reduce timing risk.
Q3. How many factor funds should I own?
Usually 2–3 complementary factors are enough for diversification without overcomplication.
Q4. What’s the right holding period?
Treat factor tilts as multi-year strategies. Review annually; avoid frequent switching.
Q5. Tax treatment?
Most domestic equity factor funds are taxed like equity-oriented schemes. Verify classification before investing and consult your advisor.
Key Takeaways
- Factors are transparent, rules-based ways to tilt portfolios toward proven characteristics.
- Combine complementary factors and keep costs, turnover, and tracking difference in check.
- Use a core–satellite approach, rebalance calmly, and evaluate over full cycles.
- For most investors, Indian factor ETFs provide a practical, regulated route to factor exposure.