by Rolf Agather, managing director, research & innovation
The rise of factor investing has been noteworthy investment trends of the past decade. A growing number of investors have implemented or are considering factor strategies, as they’ve learned factors can be an effective tool for targeting more precise risk and return outcomes. But while some might think this new era of factor investing is casting the traditional style box into obsolescence, the reality is factor indexes aren’t designed to replace style indexes—in fact, the two strategies can be complementary.
While widespread factor investing adoption is relatively new, style investing has a history that spans over more than three decades. In 1987, Russell created the industry’s first style indexes to provide investors more accurate benchmarks for measuring growth and value equity market segments. Standard market cap weighted indexes, such as the Russell 1000 could be an effective benchmark for some US large cap active managers, but were not the right yardstick for strategies that were designed to tilt toward value or growth stocks.
Growth and value indexes need to be market cap-weighted and two-sided, meaning they’re designed to split the broader market segment into two complementary components. For example, the sum of the Russell 1000 Growth and Russell 1000 Value is the Russell 1000. And while the history of these style indexes is extensive, their objective is timeless—they continue to make excellent benchmarks for evaluating the skill of active managers.
Factor indexes are constructed with a different set of objectives. They are not designed to be benchmarks for active strategies. Relative to styles, they’re designed to be more targeted, aiming to capture more precise levels of exposure to a stated factor such as low volatility, momentum, quality or value. As shown below, most factor indexes are factor-weighted as opposed to market cap-weighted, and when compared to style indexes they tend to have fewer constituents and higher turnover. They’re also generally one-sided, designed to focus on a singular direction.
This comparison underscores how much style and factor indexes differ in their objectives. As such, they serve distinctly different purposes. For over three decades, style indexes have made—and continue to make—great core benchmarks for evaluating active manager skill. And funds tracking them can be used to express active views along the growth/value dimension, or to neutralize undesired style tilts introduced by active managers.
Factor indexes can be used alongside style indexes as tools for targeting specific portfolio outcomes with precision. Funds tracking them can give investors the ability to tailor portfolios to their unique risk/return objectives. In this sense, factor indexes are not a modern replacement for style indexes, but rather a complement.
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