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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.

 

 

Alternative approaches to multi-factor index construction: Like-for-like comparisons

Lingjuan Ma, research analysts at FTSE Russell, highlights the merit of diversification when comparing top-down versus bottom-up multi-factor approaches. Download the research paper

 
 

Factor Indexes and Factor Exposure Matching: Like-for-Like Comparisons

The first paper in our factor series introduces empirical evidence of what academics have been telling us for many years – that factor exposures matter. FTSE Russell’s Andy Dougan, director, research and analytics, gives a brief video summary. Download the research paper

 

Smart Beta: Classification & Sample Range

We believe simplicity is key when looking at Smart Beta indexation.

Framework

 

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.

Single Factor & Multifactor Indexes

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

Implementing factor investing (10:39)

Marlies van Boven, managing director of research and analytics at FTSE Russell meets Francesca Fabrizi, editor in chief at European Pensions, to discuss her recent paper. The video interview covers some of the fundamental questions market participants ought to consider before deploying a factor based investment strategy.

 

2018 Global Smart beta survey of Asset Owners (1:25)

Now in its fifth year, the FTSE Russell global institutional smart beta survey provides a clear insight into major trends at work in recent years in awareness, popularity and use of smart beta index strategies among global institutional asset owners.

 

Getting smart with sustainability (10:20)

Pensions Age speaks to FTSE Russell to discuss Smart Sustainability, the new index methodology from FTSE Russell which combines sustainable parameters with ‎risk premia via factor exposure.

 

Factor indexing and ETFs (5:44)

Romana Raj and Stephane Degroote of FTSE Russell are joined by Matthieu Mouly from Lyxor Asset Management to discuss smart beta and factor indexation and to explore the reasons for the rapid growth in this asset class

 

Peter Gunthorp, Managing Director, Research & Analytics discusses some of the key features of the FTSE Russell Minimum Variance Index (3:55)

The objective of the index is to reduce overall volatility while maintaining ‘healthy’ diversification. Minimum variance portfolios are not necessarily comprised of low volatility stocks; the volatility reduction stems from the correlations between individual stocks volatilities. Thus a Minimum Variance portfolio could well contain a number of very volatile stocks that offset each other.

 

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