Index and factor investing
An index fund buys the whole market at very low cost. Factor funds tilt toward traits that research links to higher long-run returns.
Why index funds work
Before costs, all investors together earn the market's return. After costs, the average active investor must earn less. That simple arithmetic, set out by Nobel laureate William Sharpe, is why low-cost index funds tracking the Nifty 50 or Sensex are hard to beat over long periods, especially among large companies.
Check two numbers for any index fund: the expense ratio and the tracking error (how closely it follows the index).
Value
Cheap relative to earnings or book value.
Momentum
Stocks that have risen most recently.
Quality
High, stable profits with low debt.
Low volatility
Stocks that move less than the market.
Size
Smaller companies, with more risk.
Market
The core: the whole index, at the lowest cost.
Factors
Academic research has identified traits, called factors, associated with long-run excess returns: value (cheap relative to fundamentals), momentum (recent winners), quality (profitable, low-debt companies), low volatility and size (smaller companies).
In India, factor or “smart beta” index funds track indices such as Nifty 200 Momentum 30, Nifty 100 Low Volatility 30 or Nifty 200 Quality 30.
The catch
Every factor goes through long stretches of underperformance, sometimes several years. Factor investing only works if you can hold through them. Treat factors as a satellite around a broad-market core, not a replacement.
Key takeaways
- 1After costs, the average active investor trails the index.
- 2Factors: value, momentum, quality, low volatility, size.
- 3Use factors as satellites and expect long dry spells.
Try it with your own numbers
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Educational content, not investment advice. Figures are illustrative.