By: Tom Goodwin, Sr. Research Director
FTSE Russell’s 2015 Smart Beta survey found that among respondents who were evaluating more than one smart beta strategy, over half shared the same objective: to understand how the strategies worked in combination. To help explain this, we’ve recently explored the effects of combining factors in indexes and found that there are smart—and not-so-smart—approaches. We’ve identified sequential tilting as an effective approach, as it can offer multiple factor exposures without diluting the index diversification.
As interest in smart beta strategies has increased, so too has the number of ways to incorporate them. Among those market participants now embracing smart beta, a growing number are evaluating how to use these strategies to achieve multiple factor exposures. But one of the challenges they now face is how to take advantage of the diversification effects of multiple factor exposures without the factors themselves cancelling each other out.
Two common approaches to achieving multiple factor exposures within an index are to average stock weights across a number of single factor indexes (a composite index approach), or use an average of the target factors to create a factor index (a composite factor approach). However, the averaging often results in a muted index exposure to all factors.
The resulting diluted index factor exposures can translate to lost diversification benefits. For example, weak levels of quality exposure in an index provide limited downside protection in a risk-off environment, while limited value exposure in an index will constrain the index’s upside performance when the market cycle returns to rewarding the value risk premium.
Can a different factor weighting scheme really avoid this pitfall of factor cannibalization? Our research points to sequential tilting as a possible index solution. In sequential tilting, index weights are first tilted toward the first factor of interest, then that result is tilted toward the second factor, and so on. The graph below compares the factor exposure of a composite index approach with sequential tilting. While both of these approaches combine the three factors of value, quality and volatility, the graph demonstrates that the multiple tilt approach consistently maintains significantly more exposure to each single factor.
FTSE Developed Active Factor Exposure: Single Factor Indexes and Multiple Tilt Approach
Source: FTSE Russell, as at 30 September 2001 – 31 December 2014. Factor exposure is the monthly average exposure. Past performance is no guarantee of future results.Returns shown may reflect hypothetical historical performance. Please see the disclaimer for important legal disclosures.
The success of sequential tilting in preserving meaningful index exposure to multiple factors speaks to the importance of taking a holistic approach to combining factors in an index. At first glance, simply averaging individual factors separately in an index or portfolio might appear to be the most straightforward approach to incorporating a multiple factor strategy. But as we’ve demonstrated, such an approach can negate the best intentions.
© 2016 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, “FTSE TMX”) and (4) MTSNext Limited (“MTSNext”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE TMX and MTS Next Limited. “FTSE®”, “Russell®”, “FTSE Russell®” “MTS®”, “FTSE TMX®”, “FTSE4Good®” and “ICB®” and all other trademarks and service marks used herein (whether registered or unregistered) are trade marks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, or FTSE TMX.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for any errors or for any loss from use of this publication or any of the information or data contained herein.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group index data and the use of their data to create financial products require a license from FTSE, Russell, FTSE TMX, MTSNext and/or their respective licensors.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.