Rotation of Factors – Keeping up with Sharmaji ka Beta

Factor Investing hasn’t made much inroads in the Indian financial markets even though we keep talking about Value, Quality and some times Momentum. Along with Volatility and Size, the key styles of factors among the many are all the rage in the United States with assets under management exceeding 900 Billion Dollars.

2017 was a year when Size factor was the rage with small cap stocks outperforming large cap stocks. While size premium does exist, the premium doesn’t come free and instead is compensation for risks that exists in the small-cap world such as liquidity and corporate governance. 

2018 was a year when the Size factor mean reverted. Small cap stocks fell out of favor and large cap stocks gained credence with Nifty 50, the market cap weighted index being the front runner among broader indices.

2019 has been a year when the Quality factor has been in the limelight and thanks to the narratives that have been written about how great companies will keep generating returns better than the market.

The Momentum factor did well by participating in the small cap rally of 2017, got whacked a bit in 2018 due to the lag factor impacting its ability to get / stay out of stocks that had peaked and were on the way down while doing better than many other strategies this year.

The thing I want to showcase is that there is nothing that is constant and will out-perform the markets year on year. As regular readers know, I am a strong believer in Momentum factor with all my equity allocation being invested in the Momentum Portfolio. The portfolio peaked in January of 2018 and is even today down 16% from the peak even though the compounded growth rate from inception is in the range of 15.85%.

This long period of under-performance isn’t surprising and for me has been a welcome move for it allowed me to deploy a significant amount of capital and be ready and invested when the factor moves back to the limelight. While this could happen in 2020 or even in 2021, the tests I have done and the literature that surrounds factor investing and its value add provides me the belief that in the long run I can handsomely benefit. 

Buying quality stocks such as HDFC AMC or HDFC Life at valuations that make no sense today isn’t wrong as long as you are willing to stick with the same strategy over time. The expectation of returns may need to be moderated by looking at the longer term returns of the strategy vs the returns delivered in recent times, but its unlikely they will under-perform heavily in the long term.

What is risky is when people buy momentum stocks and cloak that with a growth or value narrative. A good story sells yet it also sets a trap for the investor who is unable or rather unwilling to exit when the story ends and the stock enters a phase of long term bearishness.

The best time to invest in a factor is not when everyone is talking about it, positively or negatively but when none is willing to talk about it. Currently that would be the Value strategy with cheap stocks becoming cheaper by the day thanks to lack of interest that has compounded many stocks lack of strong growth. 

Markets keep mean reverting on the long term which means what is what is not working today has a greater possibility of being back in the limelight a few years down the lane while one that currently shines takes a backseat.

The biggest advantage of factors such as Low Volatility or Momentum is that the stocks that come up in their buy list can belong to any of the factors. This in a way automatically provides for factor rotation. But if you aren’t confident of being able to move across factors, stick with the one you can stick for the long term regardless of short term performances for there will always be something that is doing better than the one you are holding.