By: Tom Goodwin, Sr. Research Director
In recent months there has been tremendous interest in factor indexing and multiple factor combinations in developed markets. But not as much has been said about factors and multiple factors within emerging markets, so I wanted to examine how FTSE Russell has approached the topic.
President Harry S. Truman once declared, “Give me a one-handed economist! All my economists say, ‘On the one hand, (but) on the other.’” Unfortunately for Mr. Truman, with complex issues, a two-handed approach may be necessary, and that is what we will pursue here.
Two hands, single factor
On the one hand, factor indexes offer rules based, transparent exposure to factors that may capture risk premiums in the long run. These strategic risk premiums are all well documented by academic and practitioner research. The table below shows the annualized returns to five single factor indexes in emerging markets going back to 2001. All five indexes demonstrated higher compound annualized returns than the FTSE Emerging Index, a broad cap-weighted benchmark index, over a full market cycle.
On the other hand, single factor indexes can and do underperform the broader market over time periods shorter than the “long run.” For example, the FTSE Emerging Value Factor Index has underperformed the FTSE Emerging Index by 8% over the last five years ending January 31, 2016. This has generated interest amongst some market participants in combining factors into a multifactor index to increase index diversification and manage risk while still maintaining strategic index exposures to factors.
Two hands, multi-factor
A common approach to combining several factors into one index has been to create a composite average of the factors. On the one hand, this method is easy to understand and straightforward to calculate. On the other hand, this often results in sharply reduced exposures to any one of the individual factors as they tend to get averaged out.
FTSE Russell’s response to this problem has been the FTSE Emerging Comprehensive Factor Index. This index is constructed by combining the five factors using a “tilt-tilt” methodology, which multiplies factor weights instead of averaging them. Our research indicates that this methodology should deliver stronger exposures to all five factors when compared to a composite average of the factors – but not without at least one drawback.
On the one hand, a drawback is that the stronger exposures to each factor can lead to relatively high tracking error when compared to the broad cap-weighted benchmark. A higher tracking error can be concerning to a benchmark-sensitive market participant who manages to a tracking error budget.
On the other hand, most market participants consider factor indexes as allocations to a larger equity portfolio, not on a standalone basis. As illustrated below, the factor exposures within the Comprehensive Factor Index are more focused than in the composite of the five single factor indexes. The result is that participants may conclude that a smaller allocation would be required to the Comprehensive Factor Index, which would in turn help to keep the overall tracking error down – challenging hand one’s argument.
Source: FTSE Russell, data as at January 31, 2016. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. Please see the disclaimer for important legal disclosures.
Over the September 2001 through January 2016 period we can see the different allocations that would have been necessary to achieve a 1% excess return target over the historical returns of the FTSE Emerging Index. Inherently, the increase in the associated tracking error of the tilt-tilt methodology is negated by the lesser allocation required for the Comprehensive Factor Index to achieve the same result. In this example, the 18.5% allocation to the Comprehensive Factor Index would have resulted in 1.0% tracking error compared to 1.3% tracking error for a 66.5% allocation to a composite index of the five single factor indexes.
So although this two handed discussion might not have been to President Truman’s taste, by addressing both hands I think we have managed to shed some light on the differences between a comprehensive and composite approach to capturing index factor exposures.
 For academic references and FTSE Russell methodology, see Factor Exposures Indexes – Index Construction Methodology, FTSE Russell (2015).
 Multifactor Indexes: The Power of Tilting, FTSE Russell (2016).
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