The benefits of staying focused

Andrew Dougan, Director, Research & Analytics, FTSE Russell

Factor-based investment approaches are rapidly gaining in popularity in multiple markets thanks to their ability to deliver positive long-term risk-adjusted returns.

In fact, FTSE Russell’s annual Smart Beta survey, which looked at whether investors are integrating factors into portfolios, revealed adoption by 58% of asset owners globally in 2019, up 10% since 2018. And within this growing field, multi-factor-based investment approaches are rapidly growing in popularity.

However, not all multi-factor indexes are created equal. The issue of “off-target exposures” remains a common concern for investors experiencing a gap between factor strategy intentions and actual outcomes.

As demonstrated in one of our earlier blogs, multi-factor indexes constructed using a Select & Weight (S&W) methodology can have large unwanted exposures to off-target factors, countries and industries.

Compared to S&W, factor tilting does not completely eliminate unwanted factors, but can significantly reduce them. Our new Target Exposure indexes employ “corrective tilts” that remove off-target exposures while staying within our simple and transparent tilting framework.

To illustrate this concept, we constructed three factor indexes, all of which target Value, Quality, Low Volatility, Size and Momentum factor exposures based on the FTSE All-World Index. The first index simply targets these factor exposures while the second and third index neutralize off-target exposures of Beta, Country and Industry.

By reducing these off-target exposures the indexes achieved progressively lower tracking error and higher information ratios—the unwanted sources of tracking error are removed, leaving only the on-target factor exposure and a more focused multi-factor index experience for the end user.  

Andrew Dougan – director, research & analytics:

“We’ve seen strong and growing interest in factor-based investment approaches utilizing indexes over the last decade. At the same time, we have continued to innovate in our methodologies to help address some challenges that have emerged for investors in this area. For example, new index approaches enable investors to capture desired factor exposures consistently over time without introducing undesired factors, often referred to as ‘off-target exposures,’ which can prove problematic.”

FTSE Russell has recently introduced the FTSE Target Exposure Indexes to give investors the ability to pursue a variety of explicit factor exposures while maintaining market, country and industry neutrality. Visit the FTSE Russell website for more information.

Photo Credit: Ryan Wick via Flickr Creative Commons

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