By: Tom Goodwin, Sr. Research Director
In a previous post, I shed light on some differences between factor and alternatively weighted indexes, which can at first glance appear to have nearly identical objectives. Now I want to take the discussion a step further, exploring which option would be more suitable for an investor seeking a tool capturing precise factor exposure. This time, a closer look at the numbers reveals a reassuring answer—as the name of the index category suggests, factor indexes can provide more precise exposure to desired factors.
Let’s start by first looking at factor exposure for the alternatively weighted FTSE RAFI Developed 1000 Index. This fundamentally weighted index departs from the traditional method of weighting by market capitalization by instead weighting by economic measures of company size such as sales revenue and book value. These economic measures are correlated with valuation ratios such as sales-to-price, which are employed in a value index. Consequently, the RAFI index has displayed an average monthly value factor exposure of 0.32 since March 2007.
However, the value factor exposure of RAFI is more incidental than intentional because the real intention is to break the link between the weight placed on a stock and its price. The objective is to create an index that is diversified away from short term fluctuations in market price that can often be driven by overreaction to news and herding behavior. A value index, by contrast, has the objective of capturing the value risk premium, and so a strong value exposure is intentional.
Because the correlation between fundamental measures and valuation ratios are imperfect, the value exposure in RAFI is usually weaker and more time varying than the value exposure in a value index. A striking example of such variation can be observed during the financial crisis in 2009, when the value factor exposure for the FTSE RAFI Developed 1000 Index became markedly more pronounced.
The chart below not only clearly illustrates this time period, but also demonstrates that the FTSE Developed Value Factor Index has persistently displayed greater exposure since 2007. This index displays a monthly average value factor exposure of 0.70, compared with the 0.32 we saw for the FTSE RAFI Developed 1000 Index.
Active Value Exposure: FTSE RAFI Developed 1000 and FTSE Developed Value Factor Index
Source: FTSE Russell. Data as at 30 July 2015. All charts use the FTSE Developed Index universe. FTSE RAFI Developed 1000 and FTSE Developed Value Factor indexes, March 2007–July 2015. Some or all data may be back tested. Past performance is no guarantee of future results. Please see the disclaimer for important legal disclosures.
In fact, the only instance where the value factor exposure for the alternatively weighted RAFI index exceeded that of the factor index was the 2009 period. And I think it’s fair to say this is because the value factor exposure for the FTSE Developed Value Factor Index is steadier by design.
This data is consistent with factor indexes’ specific objective of providing persistent exposure over time to the factor or factors of interest. And since factor exposures for alternatively weighted indexes instead tend to be byproducts of the index design, it stands to reason that factor indexes should capture more precise factor exposure.
 Source: FTSE Russell as of July 2015
© 2016 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, “FTSE TMX”) and (4) MTSNext Limited (“MTSNext”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE TMX and MTS Next Limited. “FTSE®”, “Russell®”, “FTSE Russell®” “MTS®”, “FTSE TMX®”, “FTSE4Good®” and “ICB®” and all other trademarks and service marks used herein (whether registered or unregistered) are trade marks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, or FTSE TMX.
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 any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for any errors or for any loss from use of this publication or any of the information or data contained herein.
No member of the LSE Group nor their respective directors, officers, employees, partners or 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 indexes for any particular purpose to which they might be put.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any 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 applicable member of the LSE Group. Use and distribution of the LSE Group index data and the use of their data to create financial products require a license from FTSE, Russell, FTSE TMX, MTSNext and/or their respective 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.