Multi-factor funds: Choose the right mix to balance risk and returns

Check the track record of the factor combination, tracking error and expense ratio before investing

Two asset management companies (AMCs) have launched new fund offers (NFOs) for multi-factor funds. Kotak Mahindra Asset Management Company has launched the Nifty Alpha Low Volatility 30 Index Fund and Groww AMC has launched the Nifty Smallcap 250 Momentum Quality 100 Exchange-Traded Fund (ETF). 

What are multi-factor funds? 

A factor fund, or smart-beta fund, is a passive fund that tracks an index built using specific stock-selection factors. These could be value, quality, momentum, low volatility, and alpha. 

“Multi-factor investing combines multiple factors to reduce reliance on any one factor and deliver more balanced performance across market cycles,” says Pratik Oswal, chief of passive business, Motilal Oswal Asset Management Company. 

Mitigate style risk 

Single-factor funds suffer from a drawback. “An investor holding only one factor strategy may face prolonged underperformance for years when that style goes out of favour,” says Jiral Mehta, senior manager — research, FundsIndia. 

Combining multiple factors reduces that risk. Multi-factor funds could offer investors more consistent performance. 

“Portfolios of multi-factor funds also tend to be diversified,” says Shubham Gupta, cofounder, Growthvine Capital. 

Factor cyclicality remains a risk 

Combining multiple factors reduces the risk arising from factor cyclicality but doesn’t eliminate it. “Multiple factors can underperform at the same time,” says Raghvendra Nath, managing director, Ladderup Asset Managers. 

Back-tested results, based on which many of these funds are sold, are not predictors of performance. “Actual returns can differ meaningfully from back-tested returns,” says Gupta. 

Nath points out that many investors might find these strategies difficult to understand, and frequent portfolio adjustments could result in higher fees compared to traditional index funds. 

Pick the right strategy 

Evaluate a fund’s performance across different market cycles, instead of focusing only on recent returns. “Choose a fund built on a strong real-world track record,” says Mehta. 

Understand the nature of individual factors. “Quality and low-volatility factors are aimed at improving portfolio resilience. Momentum and alpha factors are more return-seeking but can also be more volatile,” says Gupta. 

The factors included in a fund should match the investor’s risk-bearing capacity. 

Compare a fund’s expense ratio and track record with those of similar funds. “Lower costs and closer replication of the underlying index can have a positive impact on long-term returns,” says Satish Dondapati, fund manager, Kotak Mahindra Asset Management Company. 

“Expense ratio matters because high fees can quietly erode a modest factor premium,” adds Nath. 

Are they right for you? 

According to Oswal, multi-factor funds suit long-term investors who prefer systematic investing, want exposure to proven factors, and can tolerate periods of underperformance. 

“These funds may also appeal to investors who prefer a rules-based investment approach and are seeking the potential for better risk-adjusted returns over the long term,” says Dondapati. 

According to Gupta, conservative investors may prefer quality and low-volatility factors, while moderate-to-aggressive investors may consider quality plus momentum, or alpha plus low volatility, for higher return potential with some risk control. 

“Patient investors with a horizon of more than seven years may consider them,” says Mehta. 

“Multi-factor index funds may not suit investors who want simple, low-cost exposure, or those who cannot tolerate prolonged underperformance,” says Nath. Gupta says a 10-30 per cent allocation to factor strategies may be considered, based on risk appetite. 

 

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The writer is a Mumbai-based independent journalist