- Traditional style indexes – such as growth and value, large and small cap – are designed to represent broad market segments based on investment styles and sets of characteristics that are focused on by professional investment managers, making them excellent benchmarks for evaluating the skill of active managers.
- Factor indexes are designed to capture high levels of exposure to a targeted factor – such as low volatility, momentum, quality or value – and have given investors a new set of tools to assist them in constructing precise portfolios tailored to deliver their desired factor exposures.
- By combining traditional styles and new factor indexes, investors can construct portfolios with broad, diversified and familiar exposures while precisely tailoring their portfolio’s exposures toward or away from desired or undesired risks.
The early 1980s was a time of tremendous innovation as technological advances spurred new products and new thinking across industries, from computing to music to autos to investing. The year 1981 brought us innovations such as IBM’s first PC, the MTV video music network, the DeLorean sports car and the first institutional index fund. A few years later, Russell introduced its U.S. index series, including the Russell 2000 Index, the first small cap benchmark. Soon after, Russell introduced the first growth and value style indexes. Together, these size and style indexes formed the basis for the now well-known “style box” and have shaped the way investors construct portfolios for many years.
Since that time, indexing has grown dramatically and we are now seeing another era of innovation, with the introduction of a wide variety of factor indexes focused on individual factors such as low volatility, quality, momentum and value. Investors are working to understand these new factor indexes: how factors are similar to or different from traditional styles and how investment strategies based on factor indexes can be incorporated into portfolios. Some industry practitioners have asserted that factor investing might replace traditional styles and the style box. Others, however, have questioned the benefits of factor investing altogether, cautioning against potential disappointment down the road.
So, what’s the right answer? As with any new concept, the answer is more nuanced than a simple thumbs-up or thumbs-down. Factor indexes represent new tools that investors can use to construct more precise portfolios based on their unique objectives and tolerance for risk. For many, a combination of traditional styles and new factor indexes may provide an attractive solution for their investment needs.
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