Smart Beta & Factor Indexes

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.

 

Factor Exposure Indexes

What is the index objective?

Factor indexes aim to achieve for underlying indexes an efficient & controlled exposure to ‘target factors’ - stock level characteristics that are widely considered as important in explaining a stock’s risk and return.

The FTSE Russell factor indexes use a transparent and rules-based methodology to achieve controlled exposure to the target factor(s) by re-weighting an underlying index towards the target factor(s).  Secondary objectives include ease of implementation, efficiency, and flexibility.

 

Alternatively Weighted Indexes

What is the index objective?

Alternatively weighted indexes are designed to address perceived concentration risks in capitalization-weighted indexes or to reduce volatility, e.g., FTSE Global Minimum Variance Index Series. Factor indexes are designed to replicate factor return premia using a transparent and rules-based methodology. There is an overlap between these two categories: alternatively weighted indexes have factor exposures. However, these exposures may not be stable over time and are a by-product of the index design, rather than the index’s primary objective.

Non-capitalization weighted indexes employ alternative methods to select and weight stocks. Methodology is designed to weight companies by economic size, severing the link between price and index weight. Index constituents are weighted using a composite of company fundamentals, e.g., total cash dividends, free cash flow, total sales and the book value of equity.

Video gallery

 

Smart Sustainability

Integrating factors and ESG into index-based investment strategies
white space