Indian investors are increasingly looking beyond traditional market-capitalisation-based index funds. A newer category, known as factor-based or smart-beta funds, is gaining traction by combining the discipline of passive investing with a specific investment philosophy.

The growth has been striking. According to industry data, the AUM of smart-beta equity schemes increased from about ₹7,200 crore in December 2022 to ₹37,700 crore by March 2026, more than four times in less than three years. The number of such schemes also rose from seven to 24 during the same period.

 

What exactly are factor funds?

Traditional index funds generally invest according to the market capitalisation of companies. Factor funds, in contrast, follow predetermined rules to select and weight stocks based on specific characteristics, or “factors”.

Momentum funds invest in stocks that have demonstrated strong recent price performance, with the objective of participating in continuing trends.

Value funds focus on companies that appear relatively inexpensive based on measures such as earnings, book value or dividends, with the expectation that valuations may eventually normalise.

Quality funds identify companies with characteristics such as strong profitability, healthy balance sheets and consistent earnings.

Low-volatility funds select stocks that have historically experienced relatively lower price fluctuations, aiming to provide a smoother investment experience.

There are also alpha and multi-factor strategies. Multi-factor funds combine characteristics such as value, quality, momentum and low volatility. The objective is to reduce dependence on any one factor, since different factors can perform differently across market cycles. The Nifty500 Multifactor MQVLv 50, for example, combines momentum, quality, value and low volatility.

 

Why consider factor-based investing?

The biggest advantage is discipline. Stock selection is based on predefined rules rather than an individual investor’s emotions or a fund manager’s discretionary decisions.

Factor funds also offer transparency and diversification. Investors know the broad criteria used to construct the portfolio, while the underlying index automatically rebalances according to its methodology.

They can also provide an alternative between conventional active funds and plain-vanilla index funds. Investors who want a rules-based approach but believe certain investment characteristics may offer an advantage can use factor strategies to complement their core portfolio.

However, factor investing is not a magic formula. Factors can go through long periods of underperformance. Recent market corrections have demonstrated that momentum and alpha strategies, in particular, can be vulnerable when market trends reverse.

 

Who should consider them?

Factor funds are better suited to experienced, long-term investors who understand that individual factors move through cycles and are willing to remain invested during periods of underperformance.

They can be particularly useful as a satellite allocation around a diversified core portfolio rather than replacing an investor’s entire equity allocation.

The growing popularity of factor funds reflects an important evolution in Indian investing. Investors are increasingly asking not simply, “Should I invest actively or passively?” but rather, “Which investment approach best suits my objectives and risk tolerance?”

Factor investing provides another tool in that decision-making process. But like every investment strategy, it works best when used with an understanding of its strengths, limitations and place within a diversified portfolio.

Mutual fund investments are subject to market risks. Read offer documents before investing.