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The ingenious multi-factor effect

By: Rolf Agather, Managing Director, North America Research, CFA

Hardly a week seems to go by these days without reports of a new record high for some well-known stock market index. These are almost always capitalization weighted indexes which, because of their method of construction, can become heavily weighted towards their largest constituent companies. For market participants who wish to mitigate the tendency towards index concentration, as we discussed in an earlier blog post `Understanding the “why” of smart beta’, multi-factor based indexes are an increasingly popular alternative.

By incorporating each constituent’s factor scores into its weight, these indexes seek to select a diversified combination of the primary contributors to equity market performance. To maintain these diversification objectives, semi-annual rebalancing is required.

The FTSE Global Factor Index Series includes both single factor and multi-factor indexes. Under this umbrella are the FTSE Comprehensive Factor Indexes—a set of five multi-factor indexes based on the following well-known cap-weighted indexes: the Russell 2000® Index, Russell 1000® Index, FTSE Developed Index, FTSE Developed ex US Index and the FTSE Emerging Index. Using each of these as a starting universe, the comprehensive factor indexes are then designed to be diversified among five factors: value, quality, momentum, volatility and size. Empirical evidence has demonstrated that these five factors often maintain a low correlation to each other potentially resulting in lower index volatility when combined in an index.[1] 

Unlike other classification methodologies where a constituent company is only included in one category— such as a sector or country—a constituent company in a multi-factor index can be included in any or all of the five factor categories. To rebalance the FTSE Comprehensive Factor Indexes, FTSE Russell uses a ‘tilt-tilt’ methodology. As seen in the example below, each constituent weight in the relevant cap-weighted benchmark is modified by its five factor scores and then rescaled to 100% to get the final factor weight used to construct the relevant comprehensive factor index.

Multi-Factor Weighting Methodology Example

Source: FTSE Russell. For illustrative purposes only.

Using the FTSE Developed ex US Comprehensive Factor Index (ex US Comprehensive Factor Index) as an example, we can see the resulting impact of rebalancing over time. The chart below shows the factor exposures and their relative dominance within the ex US Comprehensive Factor Index. We can see that rebalancing results in maintaining consistency among the relative weightings of each factor as they change over time. Rebalancing also helps to capture market trends as they emerge, such as the increasing influence of the quality and momentum factors in recent years.

Rebalancing impact on factor exposures of the FTSE Developed ex US Comprehensive Factor Index

Source: FTSE Russell as of September 19, 2016. Active factor exposure = weighted average Z score of index – weighted average Z score of benchmark (FTSE Developed ex US). (A z-score indicates how many standard deviations an element is from the mean). Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. Please see the disclaimer for important legal disclosures.

As illustrated below, this alternative method of diversification has experienced higher performance than its market-cap weighted benchmark, the FTSE Developed ex US Index. In addition, the ex US Comprehensive Factor Index has demonstrated higher risk-adjusted performance and a higher Sharpe ratio—0.69 compared to 0.32 over its market-cap weighted benchmark for the same period.[2]

Performance of the FTSE Developed ex US Comprehensive Index compared to the FTSE Developed ex US Index

Source: FTSE Russell. Data covers time period September 30, 2001 to September 30, 2016. Past performance is no guarantee of future returns. Returns may reflect hypothetical historical performance. Please see the disclaimer for important legal disclosures.

As with any index, rebalancing constituent weights plays an important role in maintaining stated index diversification objectives. In the case of multi-factor based indexes, the semi-annual rebalancing works to ensure that the more quickly changing factors maintain their relative relevance in the index. Although complex, the rebalancing methodology of an index such as the FTSE Developed ex US Comprehensive Factor Index has resulted in higher index returns while reducing index level volatility when compared to its cap-weighted benchmark.

For more information on FTSE Russell’s factor indexes and other smart beta products, please click here.

 
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[1] Source: FTSE Russell for the period June 30, 2001 through June 30, 2016.

[2] Source: FTSE Russell. Data from September 2001 through September 2016. Past performance does not guarantee future results.

 

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Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.  

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