Asset owners and asset managers are increasingly interested in so-called “smart beta” indexes, a category that includes factor and alternatively weighted indexes. In a series of four FTSE Russell Insights, we explore the concept of factors in depth. We examine the differences between factor indexes and other types of smart beta index, illustrate how factor exposure is embedded in an index and suggest how factors can be combined most effectively.
In this Insights, the third of the series, we illustrate how an index can be designed to provide controlled exposure to a factor.
Achieving controlled and meaningful factor exposure in an index
A factor index has the objective of providing controlled and meaningful exposure to the factor (or factors) of interest using a transparent and consistent methodology.
Factor indexes can serve both as benchmarks and as the basis for index-replicating financial products. As a result, index designers also need to consider levels of index capacity, diversification and turnover.
There is a trade-off between some of these characteristics: for example, maximizing the factor exposure of the index would likely lead to excessive concentration in a few stocks; and maintaining high levels of factor exposure through more frequent index reviews has implications for index turnover.
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