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Targeting factor exposures: Precision tool or blunt instrument?

Targeting factor exposures: Precision tool or blunt instrument?

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.[1]

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.

Those looking for a deeper dive on this topic can refer to our published research paper, Factor Exposures of Smart Beta Indexes, as well as a series of related Insights pieces.


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[1] Source: FTSE Russell as of July 2015


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