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.
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