Smart beta investors are increasingly looking for more sophisticated multi-factor solutions and across a range of asset classes, according to a new FTSE Russell report.
Published this month, the FTSE Russell ‘Evolution of factor investing’ paper says the top two concerns among institutional investors were how to select the best smart beta strategies and managing “unintended factor biases”.
“In fact, a lively debate has unfolded this year between those who advocate factor timing—seeking to move into and out of factors on the basis of valuations—and those who suggest that a more static allocation over time makes sense,” the report says.
However, the FTSE Russell paper says combining factor indices in a naïve fashion increases the risk of diluting the underlying sources of return.
Instead, the index provider advocates the use of a ‘tilt on tilt’ strategy that “basically identifies a group of stocks that have relatively high exposures to all of the factors” of a selected combination.
According to FTSE Russell, a “composite multi-factor index” would give investors exposure to about 25-30 per cent of the underlying single factor indices.
“… while the multiple tilt index retains approximately the same level of exposure as the single factor indices,” the report says.
In the paper, Peter Gunthorp, FTSE Russell head of research and analytics, says combing factors does create the risk “that we will start to over complicate and lose the benefits of transparency and simplicity”.
“We’ve argued against having different methodologies for different factors, single factors or factor combinations. We want to use something that is general and robust enough to work across different objectives,” Gunthorp says. “This allows us to answer questions analytically; if we are asked to stress a particular factor combination we can do it in the same way and know that it is the factor piece that is driving outcomes rather than some insidious detail in the construction.”
Smart beta is also set to move beyond the traditional equity asset class, Yazann Romahi, JP Morgan Asset Management managing director, says in the FTSE Russell report.
“Factor based investing is fundamentally cross asset and therefore applies just as much to fixed income, currency, commodities and alternatives,” Romahi says. “Fixed Income especially is likely to be a major growth area in the near term because traditional indices in this space have an adverse selection problem. In other words, market cap weighted fixed income indices, by definition; mean an increasing allocation to the most profligate debtors.”
Furthermore, he says factor investing could “democratise” access to hedge funds by moving into the long/short space.
Gunthorp says active fund managers were also watching the development of factor-investing strategies with interest. He says FTSE Russell has had “discussions around the extent to which one can replicate certain active outcomes within a factor framework”.
“Ultimately, this comes back to issues of cost and beliefs around active management,” Gunthorp says.
“There is a view that money will flow out of the passive products, the active side as well and into factor based products. What this creates is a bigger opportunity for those active managers who have genuine skill; it’s just that the definition of skill has moved on. It’s not alpha relative to market cap anymore but alpha relative to some value, quality, momentum low volatility construct.”
FTSE Russell was formed in 2015 as owners, the London Stock Exchange (LSE), combined the FTSE and Russell index businesses. LSE bought Frank Russell in 2014 for US$2.7 billion, flicking off the Russell Investments arm to two US private equity firms for US$1.15 billion.
About US$10 trillion of assets globally are currently benchmarked to FTSE Russell indices.