By: Andy Dougan, director, research and analytics
Factor Index construction is a topic widely discussed at the moment. A major area of debate concerns the construction of multi-factor indexes. Should construction be top-down where separate single factor indexes are created and then combined by averaging weights? Or should the construction be bottom-up where a single integrated top-down portfolio is formed by weighting stocks in consideration of their all factor characteristics simultaneously? In this theoretical paper we consider three approaches, one top-down and two bottom-up, that shed some light on this dilemma.
Any previous attempts to compare top-down versus bottom-up approaches focus only on the dimension of factor exposure, whereas we emphasize that to make precise like-for-like comparisons we must also consider another dimension, i.e., portfolio diversification. In other words, factor exposure can only really be compared when portfolios display equivalent levels of diversification. Alternatively, matching the factor exposures of alternative construction approaches allows one to sensibly compare levels of diversification.
Therefore, we argue that confusion around superiority for top-down and bottom-up approaches stems from not incorporating both of these dimensions. In particular, we demonstrate that a popular top-down approach consisting of a composite of single factor Selection and Weighting portfolios has a superior exposure-diversification trade-off to a bottom-up Selection and Weighting approach based on a composite multi-factor for diverse portfolios for highly positively correlated factors. For concentrated portfolios and negatively correlated factors, the opposite is true.
Finally, we demonstrate that the bottom-up approach of multiple tilt always displays a superior factor exposure-diversification trade-off compared to the top-down approach.
Chart 1. Multiple Tilt versus Composite Index
Source: FTSE Russell. All data is hypothetical and for illustrative purposes only. Please see important legal disclosures.
For more information, download FTSE Russell's theoretical paper on Alternative approaches to multi-factor index construction
© 2018 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 Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE GDCM”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”) and (7) The Yield Book Inc (“YB”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE GDCM, MTS Next Limited, Mergent, FTSE FI and YB. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “WorldBIG®”, “USBIG®”, “EuroBIG®”, “AusBIG®”, “The Yield Book®”, and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks 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, FTSE GDCM, Mergent, FTSE FI or YB. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. 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 accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell Indexes is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
No part of this information may beproduced, 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 data requires a licence from FTSE, Russell, FTSE GDCM, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.