Demystifying factor-based investing: A new opportunity for investors

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Imagine you’re shopping for shoes on Amazon. You start with thousands of options but gradually narrow your search using filters like category, colour, size and material until you find the perfect pair. This process mirrors the concept of factor investing: using specific criteria, or factors, to filter and select investments.

Factor-based index funds, also known as smart beta or strategic index funds, are a sophisticated extension of passive investing. These funds invest in stocks that are part of indices created by NSE or BSE but with a twist. Traditional indices like the Nifty 50 or Sensex are built around companies’ market capitalization. Factor-based indices, however, use specific filters—such as momentum or low volatility—to refine the selection process.

In essence, factor-based index funds sit between active and traditional passive funds. They retain the transparency and cost efficiency of passive funds while incorporating some of the precision associated with active management.

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Broadly, factors can be categorized into technical (price-based factors) and fundamental (balance sheet-based factors). Examples of price-based factors include momentum, low volatility, alpha, and beta. On the other hand, fundamental factors focus on metrics like quality or value derived from a company’s financial statements.

Some indices are based on a single factor, while others combine multiple factors. For example, the Nifty 100 Low Volatility 30 index includes the 30 least volatile companies among the Nifty 100. The Nifty 500 Multicap Momentum Quality 50 (MMQ 50) index combines momentum and quality factors to select its