Factor investing: How you can avoid mutual funds and create your own stock portfolio

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Fund management has often been held in much higher esteem than it really deserves. This is especially true of large-cap core equity funds. Most of these funds are ‘closet index funds’ – i.e., the portfolio weights for stocks are fairly close to those of the benchmark. 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 side-step 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 on and which ones to go underweight. This comparison of overweight and underweight is vis-à-vis the benchmark. Given the competitive pressure to outperform, fund managers tweak the benchmark weights of stocks based on their assessment. This ability to judge – their core skill – is typically based on attributes of the companies such as valuation, management quality, profitability, growth, return on equity, governance and prospects of the sector.

Till recently, most fund managers had a certain halo around them. They were 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 (say top 200) 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. A lot has been said about value over the years, including by veterans such as Charlie Munger. It is essentially having the stock price to earnings ratio lower than one’s peers (or low P/E). Price to book is also a value indicator. 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 stock price. Momentum factor refers to the long-term upward trend in earnings growth and stock price.

Academic research in quantitative finance regularly unearths new factors. Recent additions have been liquidity and news sentiment.

The following graph shows returns statistics on relative performance of some factors in Indian context between 2007 and 2020. For comparison, the benchmark and category average of mutual funds is added too.

It is clear from the graph above that category average of large-cap mutual funds has been nearly at par with the benchmark. On the other hand, the performance of most factors has been higher by 3-4 percent a year than that of the benchmark and mutual funds.

The mathematics of factor investing

In its simplest form, a factor portfolio can be constructed by creating tilts out of the normalized factor values. The tilts determine the extent of overweight and underweight for each stock. For example, consider earnings to price ratio used as a factor. Say, stock A has an E/P of 1.5 times the average E/P of the universe and another stock B that has 0.9 times the E/P of the average. Stock A then will have a tilt of 1.5 times and B a tilt of 0.9 times. However, stock A may constitute only 1 percent of the universe by market capitalization while stock B makes up 4 percent. In this case, the weight of stock A in the value factor portfolio would be 1.5 percent while that of B will be 3.6 percent.

The weighting by market capitalization makes the default portfolio equal to the benchmark. Hence the last step. The tilts create over/under weights in proportion to the value of the factor. The resulting portfolio will now reflect a view that the ‘value factor’ will perform well in future.

Factor performance and diversification

As with anything else in capital markets, there are no guarantees in factor investing either. In the long term, most of the well-known factors perform better than benchmark. However, in a given year, a single factor may underperform. It makes sense to create a multi-factor portfolio to stabilize outperformance in the short term as well. The good part is that the factor investing math is additive in a straightforward manner. You can allocate 20 percent each to five factors and add the portfolio weights of stocks in each factor portfolio to construct the multi-factor portfolio.

Such a portfolio closely resembles what a typical mutual fund manager may come up with as well. The good part is that you don’t need to pay fee of 2 percent per year for it!

Implications for investors

Given the wide availability of financial performance data of listed companies, it is possible for investors to create factor portfolios of their own. They can also take the help of their fee-only advisors (RIAs) to understand these ideas better and to collate the relevant data. An investor can also start by creating a ‘paper’ factor portfolio and track its performance, rebalancing etc for some time to get comfortable with it before investing real money in it.

For savvy investors, factor investing should soon come to replace core equity mutual funds.