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The rise of factor investing

Smart beta is a generic term describing indexes that depart from the standard approach of weighting index constituents by their market value. It is both a popular and an unwieldy concept.

It’s popular because an increasing number of investors wish to alter the index risk and return outcomes by modifying the design of the capitalization‑weighted index. It’s unwieldy and imprecise because smart beta indexes span many non‑standard index approaches and they may be viewed from different perspectives.

The first wave of smart beta index products was concerned with addressing index concentration and reducing volatility. Such products embed a set of implicit factor outcomes and were followed by products that explicitly targeted specific factor outcomes. In this article we provide an overview of why factors matter and how investors are using them.

How factors help us to understand markets’ behavior

A factor is a common driver of stock returns. The component of stocks’ returns that is driven by factor exposure (i.e., from exposure to systematic risk) is seen as distinct from the stock-specific (non-systematic) component. In the Capital Asset Pricing Model (CAPM), which was introduced in the 1960s, a single market factor explains stocks’ returns. This market factor carries an associated risk premium, called the equity risk premium.

However, over time empirical evidence has emerged indicating that other characteristics, such as stocks’ valuation and size, also help explain their performance over time. For example, stocks with lower price-to-earnings ratios (value stocks) have shown a tendency to outperform those with higher price‑to-earnings ratios over the long term. And small-capitalization stocks have outperformed the shares of larger companies over the long term.

Empirical evidence of other equity factors has been identified and these factors have achieved wide acceptance amongst investment practitioners. In parallel, a burgeoning literature that attempts to rationalize the existence of such factors has evolved. The explanations for their existence range from compensation for bearing risk, structural market rigidities and behavioral causes. FTSE Russell’s global factor indexes cover the following equity market factors: value, size, momentum, volatility, quality, liquidity and yield. A factor index is designed with the intention of capturing the return premium or premia associated with exposure to a factor or set of factors in a transparent, rules-based and replicable format. Factor indexes can be used both as benchmarks for the performance of actively managed funds and as the reference or benchmark index for an index-replicating product.

Interest in the factor approach now extends beyond equities and into other asset classes, such as fixed income, currencies and commodities.

Interest in factors is rising

In early 2016 FTSE Russell conducted its third annual survey of global asset owners’ use of smart beta, including factors.

This year’s survey provided evidence of the rapidly growing interest in this area, and a couple of things stood out in the results.

First, European investors are leading the way in adopting smart beta. By 2016, 52% of the European asset owners surveyed had adopted smart beta, compared to 28% in North America and 38% in APAC.

Second, the most popular type of smart beta strategy among survey respondents was multi-factor combinations. Investors are increasingly looking at how to combine factors, rather than examining individual factors or other smart beta strategies in isolation. 

Factor combinations are often sought, since the behavior of individual factors is variable and they display relatively low correlations with one another. For example, the global size factor within the Russell 1000 Index had a positive year in 2009, with the prices of small-capitalization stocks rebounding from the depths of the financial crisis. Momentum and (low) volatility factors did less well that year, however. More recently, (low) volatility and quality factors have done well worldwide, while value has underperformed.

Unsurprisingly, therefore, many investors have expressed interest in combining factors. However, many of them say they are also unsure about how best to do so. Respondents to the 2016 FTSE Russell smart beta survey told us that determining the most appropriate smart beta strategy (or combination of strategies) and how to manage unintended factor biases were their top two concerns when evaluating smart beta.

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