What is a factor index?
A factor index is essentially constructed to reflect the performance of a specified factor. While alternatively weighted or “smart beta” indexes are broadly defined as a departure from the traditional market capitalization weighted approach, the factor index is narrowly focused on delivering factor exposure with a rules-based approach. Alternatively weighted indexes may exhibit incidental exposure to certain factors, but such outcomes are not intentional or controlled.
The distinction is perhaps best illustrated by comparing the minimum variance alternatively weighted indexes and low-volatility factor indexes. The objective of both indexes may appear similar but the composition of each index is in fact quite different. The low-volatility factor index has the sole objective of reflecting the performance of low volatility stocks and therefore limits its constituents to only these securities. By contrast, the alternatively weighted index seeks to lower overall benchmark volatility through a combination of low and high volatility stocks with low correlations to each other.
Alternatively Weighted vs. Factor Indexes
For all factor indices, index construction is key to capturing the intended factor exposure. While a factor weighted index may be perceived as the most precise exposure to a given factor, it may be at the expense of diversification and index capacity. The methodology for FTSE’s Global Factor Index Series applies a factor scoring system to determine weights, while also considering diversification and index capacity.
FTSE has recently added to its suite of factor indexes with the launch of the FTSE RAFI Low Volatility Index Series. These new indexes use a straightforward, rules-based methodology that selects low volatility stocks while ensuring investability, low turnover and large capacity. Comprised of equities with lower volatility, the index series methodology employs a filter to avoid expensive low volatility stocks and is highly diversified across industry sectors and countries.
As investors are increasingly looking to factor indexes as a source of risk premia, FTSE is committed to providing education and resources.
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