Index-tracking funds have grown in popularity and prominence, prompting investors to increasingly look for indices that screen companies according to different  attributes – not simply size. Factor investing uses characteristics such as quality, volatility, momentum and yield to enhance indices and provide greater weighting to those companies that meet the criteria being screened against. This differs from traditional strict market cap-based indices, which have drawn some criticism in the past.

A study by investment management company BlackRock shows that nearly nine out of 10 global institutional investors are incorporating factors within their investment process, and that they are doing so to increase diversification, reduce risk and gain a better understanding of risk and return.

‘Using factors allows investors to target specific stock-level characteristics in a transparent, rules-based and cost-effective manner,’ according to Mark Randall, Head of Data Solutions at the JSE. ‘Investors can build their portfolios around the specific characteristics that they believe will enhance their own portfolio’s risk or return metrics over time. By using standard factor definitions that enjoy broad academic and practitioner consensus, this exposure can be achieved without the individual extensive stock analysis typically required.’

Factor indices can be used to gain a better understanding of the factor exposures that are common drivers of stock returns, outside of stock-specific components. Randall says the next step is to use factor indices to understand and measure the performance of their own funds.

If an investor or manager actively follows a strategy of investing only in high-yield stocks – or follows a value strategy – then their relative performance should be measured against a benchmark that is constructed on the same principles, rather than a broad market index. This will allow the investor to ensure that their outperformance is due to stock selection – ‘alpha’– rather than being lifted by a specific factor-driven tide. Finally, investors can gain cost-effective access to specific factors through passive index funds, allowing them to gain access to diversified portfolios of stocks that have already been screened for the factor of interest.

While there are some existing ‘smart beta’ products – those that use alternative index construction methodologies – in the local market, the JSE launched eight new factor indices together with its partner, FTSE Russell. It has done so to meet the growing demand from clients for these kinds of investing strategies, and all use the FTSE/JSE All Share Index as the base.

‘The six single factor indices launched are momentum, quality, size, value, volatility and yield. These indices take the approach of starting with a market cap-based universe, namely an All Share Index capped at 5%. The weight of individual stocks is then “tilted” up or down with a potential improvement in risk-adjusted index outcomes,’ says Randall. ‘FTSE/JSE indices include additional constraints around liquidity, capacity and diversification – all within a rules-based and investable framework.’

The underlying metrics used in the factoring vary from 12-month cumulative total return for the momentum factor, to calculations based on return on assets and leverage in the case of the quality factor.

A further two multi-factor indices round out the eight. The FTSE/JSE All Share Volatility Focused Index uses tilts on quality, value, size and a ‘double-tilt’ on volatility, while the FTSE/JSE All Share Comprehensive Factor Index uses tilts on all the factors, except yield.

‘FTSE Russell’s unique tilt-tilt approach means that multiple factors can be combined in a controlled manner, without the factor selections acting against each other, and effectively “cancelling out”. This approach is used to diversify across several factors. These combinations have been chosen for their successful track record across a range of global markets and geographies, and this plays out in the South Africa back-testing results,’ says Randall.

‘The methodology also allows for additional single and multi-factor indices to be built in the future, including a range of independent metrics ranging from ESG and sustainability ratings to currency hedging attributes. Investors are able to rapidly build their own custom indices using any combina-tion of the existing factor tilts, or other screens.’

By Hilton Tarrant
Image: Gallo/GettyImages