Comparing alternative approaches to multi-factor index construction
The increasing use of multi-factor indexes by market participants has sparked much debate about the merits of differing construction methodologies. 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 portfolio is formed by weighting stocks in consideration of their all factor characteristics simultaneously?
In “Alternative approaches to multi-factor index construction: Like-for-like comparisons,” our second factor paper of this series, we undertake a theoretical comparison of the exposure and diversification outcomes of multi-factor portfolios that use a composite Index, a composite factor and a multiple tilt approach to index construction.
It is not clear cut whether a composite index or composite factor approach provides investors with higher factor exposures for the same level of diversification. However, multiple tilt as a form of bottom-up approach exhibits higher factor exposures for any levels of correlation and for both concentrated and diverse portfolios.
Bottom up vs. top down – Sequential tilting explained
In many cases, factors are the dominant driver of portfolio performance. But how a portfolio is constructed – how those factors are included in it so they don’t have unintended effects on it – is vital.