By: Tom Goodwin, senior research director
As factor investing has made its way into the mainstream, a lively debate has begun regarding the best way to combine multiple factors into a single index. At FTSE Russell, we have created a bottom-up sequential tilting or “tilt-tilt” methodology. Unlike a top-down approach — which simply takes the weighted average of single factor indexes — we found the tilt-tilt methodology minimizes the dilution of competing factors. By preserving factor exposure, the tilt-tilt approach results in an index that has the potential to capture a greater share of risk premia associated with the targeted factors.
The debate surrounding multi-factor index construction has centered on two approaches: a multiplicative tilt methodology and a multi-factor composite index approach. Each of these approaches is summarized below.
Our research indicates that when compared to the multi-factor composite index approach, the FTSE Russell tilt-tilt approach provides an effective means of pursuing multiple factor objectives via strong factor capture. To demonstrate this, we started with the FTSE Developed Index universe of stocks and set out to create a combination of high quality, low volatility and value factors. In the combination, the high quality and low volatility factors are positively correlated, while value tends to be negatively correlated with the other two factors.
We constructed two hypothetical multi-factor indexes: a composite index and a multiple tilt-tilt index, and looked at the time period from September 2000 to January 2017. As the chart below shows, the Tilt-Tilt Multi-Factor Index exhibits stronger exposure than the Composite Multi-Factor Index for each of the targeted factors.
The chart below illustrates how the differences in exposures between the Tilt-Tilt and Composite indexes would have been reflected in performance. The dilution of the factor exposures in the composite construction would have resulted in an index that is less distinguishable from the cap-weighted FTSE Developed Index.
Moreover, the gap in factor exposures between Tilt-Tilt and Composite indexes increases directly with the number of factors. If we look at a progression of adding factors one a time, we can see below that as more factors are added, the percentage of single factor exposures captured steadily decreases for the composite index. That’s because a linear combination of factors tends toward dilution of factor strength, while the multiplicative combination of factors in the tilt-tilt index maintains meaningful levels of factor exposure.
In essence, the FTSE Russell tilt-tilt approach can result in stronger exposure to desired factors than a multi-factor composite index approach. Please refer to our research paper, “Multi-factor indexes: The power of tilting" for a deeper dive into this topic.
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