How a multi-factor strategy may work in smallcap investing
The idea is to attain certain risk and return profiles which are not specifically targeted in a plain vanilla index like Nifty 50 where the selection and allocation of assets is simply based on market cap. This is done by using factors like low volatility, quality, equal weighing, momentum etc. which have worked well historically to generate potentially higher returns.
Let’s take an example, Nifty 100 index represents the top 100 companies based on full m-cap and measures the performance of large cap companies where the weight of each stock is based on its free-float m-cap. A factor-based index like Nifty 100 Quality 30 tracks the performance of 30 Quality companies, chosen based on profitability, financial health and earnings stability from the Nifty 100 Index. On the other hand, the Nifty 100 Alpha 30 index, selects and tracks companies which have generated Alpha over the market in the last 1 year. In both the indices, weights are also tilted towards stocks having better performance on the concerned factor and these portfolios are reconstituted periodically.
Now, while investing based on factors like quality, momentum etc. has worked reasonably well in the long-term horizon, especially from one favourable cycle to the next, and can be used to target certain behaviours and return-risk profiles, they come with their own set of risks. Firstly, the performance of a single factor-based portfolio can be cyclical. For example, in bull markets, momentum is expected to perform better than a low volatility factor or
