How traditional investing differs from rule-based active investing — Key points to remember

Rule-based active investing refers to following a quantitative methodology of selecting stocks using a defined set of metrics. No emotional bias or discretion is added when choosing the stocks. There are many rule-based models, but the most common and the one which we will discuss uses the concept of “factors” to construct portfolios.

Factor investing emerged from academic research, starting with the influential CAPM model, which showed that returns can be explained by the beta of a security. This concept was further crystallized into a robust framework by Fama and French who further added the value and size factors to it. Academicians have since studied over 300 well documented parameters, most of which can be classified into five commonly known equity factors; value, quality, low volatility, momentum and size.

Each factor offers a distinct source of risk adjusted returns which can be obtained over a reasonably long period of time. They also have their own cyclicality in returns over the short term. Each factor has a different economic rationale for their existence which contributes to explain their risk and reward behaviour.

Factor construction involves use of large datasets containing information from financial statements of companies and their prices over a long period of time. Models are back-tested to make sure they perform robustly across various business cycles and the risk adjusted return is sustainable over the long term. Robust data and available computing power allows a rule-based manager to analyse a large number of companies very quickly and select a portfolio of stocks by incorporating any new information as soon as it becomes public.

On the other hand, traditional investment style usually involves a discretionary fund manager and a team of analysts. They analyse market news and company related financial documents to research companies they are covering. Based on this research, the fund manager selects stocks to build the portfolio. The portfolio construction does not generally use any predefined rules and is largely at the discretion of the fund manager.

One of the challenges of traditional fund management is the ability of managers to analyse a large number of companies constantly. As a result, managers maintain a smaller pool of companies that they select from.

Just as discretionary managers need constant research to stay ahead, the models and parameters used in rule - based funds need constant monitoring and modification. Parameters often run the risk of losing their edge as they get overcrowded with more participants using it to invest. As such, even rule-based investments need constant research and monitoring to ensure that the models remain effective.

Globally, active rule-based quantitative funds form a large part of institutional and retail investor allocation. 7 out of the top 10 (Source: Pension & Investments - www.pionline.com, Internal Research) largest alternative funds use quantitative methods.

Even though traditional funds are still a larger part of the total mutual fund space, the share of rule-based funds is growing fast and now forms a core allocation for many investors. The reason for this is that a well-crafted factor based fund is easy to understand as the rules are well-defined. The ability to back test a model over many years also gives added confidence as investors can analyse how the rules have performed over various macro cycles in the past. This is not possible with traditionally managed funds which rely on a manager’s experience, skills and emotional biases which change through time.

Another reason for the popularity of rule-based funds is that multi-factor funds provide smoother risk-adjusted returns compared to the market over the long term. The performance of individual factors is broadly uncorrelated (or less correlated) to each other and combining them together in a multi-factor portfolio provides diversification benefits. This has the potential to provide a better risk adjusted return compared to any single factor.

Both active rule-based and traditional discretionary funds have a long history of creating wealth for long term investors. The benefit of active rule-based funds is that there is no emotional bias in the model and the rules can be back-tested over a long period of time. This provides an investor with better insights into how stocks are selected for the portfolio.

Since the approach is very different from traditional investing, an allocation to rule - based active funds can provide a diversification opportunity, especially in India where most investors have allocated most of their money to traditional managers.

It is also an opportunity to give one’s portfolio the benefit of technology and join a growing community of investors who want to stay at the cutting edge of investing. So when will you start your factor investing journey?