By: Mary Fjelstad, Sr. Research Analyst
Factor indexes have emerged as one of the most noteworthy innovations to come out of the smart beta trend, but I’ve heard varying views from industry practitioners about how they can be used in constructing portfolios.
Some have suggested that factor investing might replace traditional style investing and the style box, while others have questioned its benefits altogether. But I’ve found neither of these extremes to be the right answer—in fact, factor and traditional style indexes are two distinct types of indexes that might best be suited alongside each other in structuring portfolios.
The key difference between style and factor indexes lies in the index objective. The goal of traditional style indexes—such as growth and value, large and small cap—is to represent broad market segments based on styles and sets of characteristics that are the focus of many market participants. Factor indexes are more targeted, aiming to capture high levels of exposure to a stated factor such as low volatility, momentum, quality or value.
With differing objectives, style and factor indexes are constructed using markedly different approaches. Perhaps the most fundamental difference is the weighting scheme, where style indexes weight constituents by market capitalization but most factor indexes are factor-weighted.
Rebalancing frequency is also a distinguishing feature of the two types of indexes. Because factor indexes have the objective of consistent factor exposure, they tend to rebalance more frequently and have higher turnover than style indexes.
These varying index methodologies result in significantly different index composition. Style indexes are typically two-sided, meaning they’re designed to split a complete market segment into complementary components that sum to the whole segment. The Russell 1000® Value and Russell 1000® Growth are widely used examples of this symmetry of style indexes, where the parent index (the Russell 1000®) is divided into two distinct style components.
In contrast, factor indexes tend to be one-sided, focusing only on the direction that has historically exhibited a positive benefit over time. For example, the FTSE Momentum Factor Index is designed to capture the high momentum effect, as empirical evidence has shown that stocks with higher than average past returns have historically exhibited higher risk-adjusted returns. Factor indexes are also as a rule narrower in scope, and include fewer securities from the parent index than style indexes.
Distinguishing Factors from Styles1Active share is a widely used term for an aggregate measure of the difference in holdings (constituent inclusion or exclusion or divergence in constituent weights) between a given portfolio (or here, a style or factor index) and the parent or benchmark index. For more information on active share, see Antii Petajisto, “Active Share and Mutual Fund Performance,” 2013 Financial Analysts Journal v. 69 no. 4: http://www.cfapubs.org/doi/pdf/10.2469/faj.v69.n4.7
I think it’s because of these differences that both style and factor indexes can be used harmoniously as tools within a portfolio. As style indexes represent styles or characteristics that are a popular focus among professional investment managers, they can be used to define a portfolio’s core exposures and they make excellent benchmarks for evaluating active manager skill. Alongside these core strategies, the high factor capture of factor indexes can give investors the ability to tailor their portfolio more precisely to their unique objectives and risk tolerances.
So instead of viewing style and factor indexes as opposing forces, I think it’s time they were considered to be complementary. For many, a combination of traditional styles and new factor indexes may provide an attractive solution for their investment needs.
Please refer to the recently published Insights piece, Styles vs Factors: What they are, how they're similar/different and how they fit into portfolios, for more in-depth information on how investors are harmonizing with styles and factors.
 Levy, R., 1967, “Relative Strength as a Criterion for Investment Selection”, Journal of Finance.
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