By Alexandros Severis, Smart Beta product manager
When it comes to factor exposure, investors have a large toolbox of products to choose from, but not all tools (in this case, factor indexes) are created equal. Precise exposure, versatility of application and simplicity of construct are desirable characteristics for investors comparing factor indexes.
As financial markets nosedive, investors may direct their funds into defensive factors such as Quality, Low Volatility or a mixture of both. When repositioning, however, it is important to scrutinize whether the indexes they seek exposure to (or, in this case, refuge in) truly cater to their investments needs. Are they constructed such that the attributed performance comes from the targeted factor and not from off-target, unintentional exposure to other investment factors, industries or countries?
Let us illustrate this issue by imagining an investor in March 2018 who believes that Quality stocks in Developed markets will outperform the respective market cap index over the following six months. Accordingly, the investor decides to replicate a single factor Quality index. In the example below we analyze two single factor Quality indexes that have the same objective but are constructed in different ways.
The first vehicle is a selection and weight (S&W) index. This index construction methodology ranks the stocks in the FTSE Developed Index by their Quality score and then selects those with a score above a factor score percentile cut-off point. These chosen constituents are then given equal weights within the index.
The second vehicle is the FTSE Developed Pure Quality Target Exposure Factor Index. This index follows FTSE Russell’s Target Exposure construction methodology, which uses a series of tilts to create an index with exposure to the Quality factor and minimal exposures to unwanted factors, such as Low Volatility, Value, Size and Momentum, while also maintaining industry and country neutrality.
Despite both indexes seeking to achieve the same goal and the investor’s prediction being correct, the results are strikingly different.
As seen in Figure 1, the performance attribution shows that the FTSE Developed Pure Quality Target Exposure Factor Index outperformed the benchmark (“Total” bar). It achieved its stated goal of gaining exposure to Quality stocks and avoiding any implementation risk by limiting off-target, unintentional exposures.
The S&W index, however, underperformed the market capitalization benchmark. Delving into the attribution the reason for the underperformance is primarily the negative contributions from Low Volatility and country exposures. Moreover, despite seeking exposure to the Quality factor—which the S&W index did achieve—its poor construction meant it had a negative exposure to the Momentum factor, which presented a drag on performance.
Looking at live indexes, the story unsurprisingly is the same. The FTSE All-World Qual Vol Target Exposure Index is a multi-factor index that seeks exposure to the defensive factors of Quality and Low Volatility while maintaining industry and country neutrality. During the volatile first Quarter of 2020 it outperformed its respective market cap index, the FTSE All-World Index by 1.58%. From market peak (February 12, 2020) to trough (March 23), the Target Exposure index performed as expected outperforming the benchmark by 1.55%.
In fact, in 70% of instances when both the Target Exposure index and the respective market cap index had negative returns, the Target Exposure index outperformed. This is due to its robust index construction, which allows precision exposure to the Quality and Volatility factor while reducing off target factor exposure that could lead to a drag in performance.
The purity of the Target Exposure factor indexes has ensured that off-target exposures are restricted to a minimum—they are useful ammunition in an investor’s toolbox, ensuring a controlled exposure to an investor’s desired factor of choice, which is particularly important in times when there is little margin for error.
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