Home / Money / Personal Finance /  The importance of factor investing amid high inflation

It has been a while since inflation was even considered a problem in the US. The latest Consumer Price Index (CPI) numbers for the US stood at 9.1% year-on-year (YoY) as of June 2022, highest in the past 40 years, leaving investors spooked.

The IMF defines inflation as the rate of increase in prices over a period of time. A small level of inflation is sign of a healthy and growing economy. However, goods and services become unaffordable when it increases beyond a level.

As a result, investors tend to search for assets and sectors that perform well when inflation is high, in order to soften its destructive effect on their purchasing power. But can high inflation also be tackled by allocating to certain investment factors like ‘Value’ and ‘Momentum’? These factors pick stocks based on their specific attributes and are rebalanced periodically. To give a perspective, ‘value’ factor considers inexpensive stocks, while the ‘momentum’ picks winning stocks. As the name suggests, ‘low-volatility’ factor takes into account the least volatile and ‘quality’ factors to choose companies with strong business models.

We use the US and India as proxies for developed and emerging economies and define inflationary regimes for each.

We considered Y-o-Y CPI values for measuring inflation. For the US, the inflationary period is a defined duration before and after the CPI crosses 5%. For India, the threshold is 6%. This aligns with the RBI’s target of maintaining inflation below 6% . For both economies, the starting point is 2%, which is generally considered a psychological indicator of healthy economic growth.

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`As per the defined inflationary regime, there has been 11 periods of high inflation in the US since 1934. During these, the equity returns were -1.5%. India has witnessed 17 periods of high inflation since 1963, where the average equity market returns were 11%. We also looked at the performance of factor strategies, as highlighted in the table. The charts show the contrasting results for the two countries. Momentum, the best performing factor strategy for the US during inflation, was the worst performer in India. In contrast, the low volatility factor, the best performer in India, was among the factors with poorer performance in the US. However, most factors tend to have done reasonably well when compared to the market in both regions.

But what are the odds of the factor’s ability to beat the market during high inflation? For individual factors, the odds of outperformance varied from 17% to 100%. However, in both geographies, the equal-weighted allocation to all factors demonstrated high persistence (82% of the time beating market returns in the US; and 67% of the time in India) during the inflationary period.

Though the factors have done well in outperforming the market historically, the length of data is too short to establish any form of causation. Therefore, an equal allocation to all the factors can be a better alternative than trying to time the perfect factor.

Sankaranarayanan Krishnan is the quant fund manager (PMS & AIF) at Motilal Oswal Asset Management Company.

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