Up until the 1990s, the Capital asset pricing model (CAPM) was the dominant model used to explain market returns. But in 1992 Nobel Laureate Eugene Fama and his partner, Ken French said that market returns can be explained by three factors namely:
1. Value: the tendency of cheap stocks to outperform costly stocks
2. Size: the tendency of small cap stocks to outperform large cap stocks
3. Market factor: the risk premium of the market over the risk-free rate, like a government bond.
Over a period of time, other factors like quality, momentum, and low volatility were added. Institutions were the first to adopt factor investing but with the popularity of ETFs, around 2010, factor ETFs also known as smart beta ETFs started becoming popular in the United States. Given that Indian markets are still very young compared to the US, we just had our first wave of factor or smart beta funds around 2017. But in the last 3 years, there has been an explosion in factor ETFs and mutual funds.
But investors often think of factor investing as a guaranteed way to generate higher returns than the market. They often look at the historical returns of factors like value, momentum, quality, and low volatility and think that these factor funds will always outperform Nifty, which isn’t true. Having said that, factor investing can play a very important role in your portfolio, and it’s important to know how to use these funds in your asset allocation.
This week on the show, we caught up with Sankaranarayanan Krishnan, a quant fund manager at Motilal who has rich experience designing factor models and managing factor funds. In this conversation, we start with the absolute basics of factors investing and talk about two major factors — low volatility (low vol) and momentum. We talk about why these factors exist and the explanations, return expectations, and how to use them in an asset allocation framework.
In this conversation, Sankar talks about:
This was an absolute masterclass on factor investing, and we hope you enjoy listening to this conversation as much as we did recording it. We have an upcoming episode on the other two factors—value and quality.
We also have an introductory note on smart beta funds on Varsity, do check it out.
If you have any questions about anything discussed in the episode or thoughts in general, do post them here on TradingQnA.
If you enjoyed listening to this episode, do let us know by tweeting, we are @zerodhaonline