Comparing approaches to factor indexing

Another important observation from Figure 1 is that, similar to the market factor, the small-cap, value, momentum and volatility factors have been very volatile. In other words, the potential reward from systematically tilting the portfolio towards any of these factors can vary significantly from one period to another. The results shown in Figure 1 suggest that these well-known risk factors can all have significant impacts on both the risk and return of equity portfolios.

The impressive recent performance of some alternative beta strategies, when compared with the average returns from active managers, may also have contributed to the growing interest in alternative beta strategies. For instance, Figure 2 shows that a simple equal-weighted strategy and a low-volatility strategy have significantly outperformed the S&P 500 index over the last ten years. By comparison, the average US large-cap manager has lagged the S&P 500.

In the next section, we evaluate various alternative equity beta strategies by examining the similarities and differences in their strategy objective, underlying risk drivers, portfolio construction methodology, and historical risk and return profiles.

ALTERNATIVE EQUITY BETA STRATEGIES COMPARED

The authors of several recent studies have compared the increasingly numerous alternative equity beta strategies. For instance, Chow, Hsu, Kalesnik, and Little (2011) surveyed various "Heuristic-Based" (experience-based) and "Optimisation-Based" weighting strategies. Using a four-factor model of market, small-cap, value and momentum, the authors identified the sources of outperformance as exposure to the value and small-cap factors, and found no statistically significant alpha after adjustment for the factor exposures. Melas, Briand and Urwin (2011) proposed a generalised framework and characterised all "Risk-Based" and "Return-Based" strategies as special cases of mean-variance portfolio construction, subject to various assumptions for expected risk and return. Dash and Loggie (2008) suggested that all index weighting schemes can be generalised as being weighted by a certain factor raised to a power; if it is desired to amplify the influence of certain factor, an exponent can be applied.

One simple way to understand alternative beta strategies is that, while they all aim to achieve a better risk-adjusted performance than the cap-weighted portfolio, most strategies have a more specific objective, either explicitly or implicitly (see Figure 3). For instance, fundamentally weighted indices and dividend-weighted indices are essentially both value strategies that tilt portfolios towards value stocks. The minimum-variance strategy and other, non-optimised low-volatility strategies are designed with the same objective of achieving lower portfolio volatility than the market capitalisation-weighted portfolio, and have lower market beta and negative exposure to the volatility factor. The portfolio construction process (e.g. whether it is heuristic-based or optimisation based), while important, is secondary to the objective and underlying risk drivers of the strategy.

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