Mint Explainer: What are factor funds and how do they work?

livemint.com:

traditional passive funds that simply track an index, factor-based funds operate on predefined rules or criteria—related to fundamentals or stock behaviour—to select stocks. These funds don't have a fund manager making investment decisions, yet they aren’t as straightforward as index trackers. They rebalance at regular intervals, typically every six months, to ensure alignment with their specified factors.

Factor funds use a variety of criteria such as momentum, value, growth, quality, and low volatility. They can be categorized into single-factor funds, which focus on one specific factor, and multi-factor funds, which combine several factors in varying proportions. Experts argue that multi-factor strategies can be more effective.

“For example, a combination of momentum and low volatility can be a good strategy, as the latter can mitigate the downside risk of a momentum strategy during bear markets," says Kavitha Menon, founder of Probitus Wealth. Menon emphasizes that factor performance should not be viewed in isolation and that investors need to exercise caution when selecting these factors. “One must consider the universe of stocks that the factor is applied on.

For instance, the last few months momentum funds have outperformed. This may be due to their underlying universe which is mostly mid-caps and small-caps. As the underlying has seen a bull market, the factor too has done well.

When the performance of this universe reverses to mean, momentum may swing downwards and cause deeper corrections," she explained. The performance of different factors can vary significantly across market phases. For instance, the quality factor performed well in 2021 but was the worst performer in 2022.