Tilting vs Optimisation in the context of EU Climate Benchmarks

Key takeaways:

• Methodology choice significantly impacts index characteristics, even under the same regulatory framework
• Being intentionally more constrained by design, Target Exposure is using less leverage, is less sensitive to signal noise and is more explainable. Tracking Error Optimisation provides tighter tracking and better diversification but is less transparent and more sensitive to signal noise and risk model choice. Turnover Optimisation reduces rebalancing turnover by design but may increase leverage and reduce flexibility
• Secondary objectives like robustness, liquidity, or transparency can be addressed through hybrid constraints

Points of differentiation:

• Applies real-world regulatory requirements (EU Climate Benchmarks) to demonstrate the wide variability in index outcomes from different methodologies
• Highlights the importance of robustness, model sensitivity testing and transparency, often overlooked in index construction discussions
• Uses quantitative comparisons (e.g. leverage, turnover, tracking error) to illuminate trade-offs

What does our research mean for investors?

• Offers a practical framework to evaluate the benefits and trade-offs of index construction techniques using the EU Climate Benchmark as a case study
• Empowers investors to align index design with their portfolio goals, be it minimising tracking error, enhancing transparency, or improving robustness
• Demonstrates how FTSE Russell’s methodologies can adapt to investor-specific priorities by adjusting constraints and objectives