Factor investing is built on the premise that investors can manage risk and returns by applying an appropriate mix of equity factors such as Value, Quality, Size, Momentum and Low Volatility. Often referred to as ‘Smart Beta’, factor investing is an approach that has gained traction rapidly over the last decade and is now used to manage over $1 trillion of investor assets. [1]
This potential for unlocking returns through a factor-based approach may explain why FTSE Russell’s annual Smart Beta Survey for 2019 revealed record adoption by 58% of asset owners globally, up 10% since 2018. A growing majority of asset owners—government organizations, corporations, unions, insurance companies, sovereign wealth funds and family offices from North America, Europe, Asia Pacific and elsewhere—are discovering the potential advantages of smart beta. All this has helped move factor based investing from a niche approach undertaken by a small number of sophisticated investors to the mainstream.
Factor-based strategies that incorporate ESG, or sustainable investment considerations are also on the rise. In Europe, of those who had an existing or anticipated smart beta allocation, 77% said they might incorporate ESG considerations into that allocation. This expanding interest helps explain why BlackRock estimate factor-based strategies to be worth an estimated £3.4 trillion by 2022.[2]
Factor-based approaches can also help investment managers address portfolio concentration risk and adapt portfolios to suit changing macro-economic conditions. For example, it is well-known that Quality and Low Volatility have proven effective defensive factors during market downturns, while cyclical factors such as Value, Momentum and Size have performed best during periods of economic growth.
For example, during the 2008 financial crises a Low Volatility tilt provided some downside protection to the FTSE Developed Index, as lower volatility companies experienced smaller drawdowns. The graph below compares the risk and return characteristics of FTSE Developed Quality, Momentum, Value, Low Volatility and Size single factor indexes between September 2001 and December 2019; all five factors outperformed the benchmark over the period and four of them did so while also providing lower volatility of returns.
Source: FTSE Russell. Data from September 2001 to December 2018. Past performance is no guarantee of future results. [Factor index data represents hypothetical, historical data.] Please see the end for important legal disclosures.
As a global index provider, FTSE Russell has witnessed the growing traction this approach has achieved over the last decade, but also continues to innovate in order to solve problems faced by investors using a factor approach.
For example, capturing desired factor exposures consistently over time without introducing exposure to undesired factors, called off-target exposures, can prove problematic.
To help investors address this challenge, FTSE Russell has introduced FTSE Target Exposure indexes. The new indexes allow users to achieve a variety of explicit exposure objectives, ranging from risk factors, to industries and countries, as well as sustainable investment objectives consistently over time. The indexes are designed to deliver set levels of factor exposure at each rebalance and are regularly rebalanced to ensure this level is maintained. The launch comes as asset owners and money managers are demanding greater transparency from index providers on factor-based benchmarks and the ability to monitor factor exposures over time.
FTSE Russell does not use an optimizer. Instead, appropriate tilt strengths are determined by solving a series of equations in order to align factor and sustainable investment exposures with investment goals. This methodology allows exposures to be targeted in a precise, but more transparent manner compared to optimised approaches. This is a key differentiator for FTSE Russell.
FTSE Russell’s Target Exposure indexes give investors the ability to achieve a variety of explicit factor exposures, while maintaining market, country and industry neutrality.
This can be used for a variety of applications covering pure play single factor indexes, multi-factor indexing and to incorporate specific levels of climate objectives, such as carbon emissions from the stocks in an index.
Another reason exposure control is important is the growing demand for sustainable investment products that meet certain ESG objectives, often with a focus on reducing carbon emissions by a specific amount, or to consistently align a portfolio with the Transition Pathway Initiative goals.
Time will tell which factors perform best in 2020. Yet, as investors continue to allocate capital to smart beta funds this year, the need to provide a full suite of tools that will offer consistent exposure to desired factors while minimising exposure to unwanted factors is becoming increasingly important.
By Andrew Dougan at FTSE Russell, the global index provider with over $15 trillion of assets tracking its benchmarks.
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[1] Financial Times, Smart beta funds pass $1 trillion in assets, December 2017
[2] BlackRock, What is Factor Investing?, Andrew Ang, Ph, Nov 7, 2018
