By: Tom Goodwin, Senior Research Director
With the growing interest in smart beta against the backdrop of a looming interest rate rise expected from the Federal Reserve Bank (the “Fed”), many investors are wondering how these indexes might respond to a rate increase. Factor indexes—designed to capture the systematic return to a specific set of company characteristics—are of particular interest, given that few of them were around when the Fed raised rates in the past. In this blog post, we aim to shed some light on the consequences for smart beta by looking at simulated returns for six FTSE Russell factor indexes during the last sustained period of rising rates.
Let's take a look at the 2004 – 2007 period, when the Fed began a restrictive stance to monetary policy that led to a steady rise of the Fed Funds Rate from 1% in June 2004 to a peak of 5.26% in July 2007.
The chart above plots six simulated FTSE Russell factor indexes over this time period. The factors are momentum, illiquidity, quality, size, value and volatility.1 The returns are expressed in the form of the growth of $1 over the FTSE USA index broad benchmark.This is equivalent to cumulative excess returns over the FTSE USA index broad benchmark. Excess returns were chosen as they effectively back out common market movements that might otherwise obscure differences between the factor indexes.
The chart reveals a distinct bifurcation of the six indexes into two groups of three. One group consists of the value, illiquidity and size factor indexes which would have steadily outperformed the FTSE USA index broad benchmark during the period of monetary tightening. The second group consists of the quality, momentum and volatility indexes which would have been essentially flat against the broad benchmark during this period.
The table below shows what the compound excess returns to the six factor indexes would have been over the period of monetary tightening. It confirms what the chart shows, namely the substantial outperformance of value, illiquidity and size versus the broad benchmark-like performance of momentum, quality and volatility during this period.
It’s important to note, by the way, that these are simulated returns and that correlation is not causation, so one should exercise caution in interpreting these results. Nonetheless, as factor indexes have grown in popularity these illustrations hopefully provide an interesting perspective on an important issue.
 Reference here to relevant FTSE documentation explaining these indexes.
© 2015 London Stock Exchange Group companies.
London Stock Exchange Group companies includes FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), MTS Next Limited (“MTS”), and FTSE TMX Global Debt Capital Markets Inc (“FTSE TMX”). All rights reserved.
“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trademarks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under license.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication.
Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put.
The London Stock Exchange Group companies do not provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the London Stock Exchange Group companies. Distribution of the London Stock Exchange Group companies’ index values and the use of their indexes to create financial products require a license with FTSE, FTSE TMX, MTS and/or Russell and/or its licensors.
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.