FTSE Russell Insights

Will the real factor index please stand up? 

Ryan Giannotto, CFA

Manager of Equity Index Research

In the world of modern finance, leveraging factors is a delicate balance. We explore the dance between calibration and conviction to unlock the potential of your investments.

  • Investors face a choice of 3 main approaches when devising factor indexes—selection, tilting and optimization—each with their advantages and limitations.
  •  Every design element involves tradeoffs—what are your must- haves in a strategy and where do you have flexibility? It all depends on investor objectives.
  • There is no correct factor index, but some factor applications are more efficient than others. At FTSE Russell, we lead clients through the complex world of factor indexes to catalyze their investment perspectives.

Might just be the next best thing: factors

The proliferation of factor research has seen the classic Wall Street casino game transformed into a disciplined science.  While investors are still free to speculate wildly, advanced mathematics can isolate long term drivers of excess return, what we call factor premia, such as quality, low volatility or size.  

This scientific rigor notwithstanding, how factor scoring, and attribution models are blended into cohesive client strategies remains an artform. Confusion often arises over what is the true approach to constructing factor methodologies; here we review three leading strategies used in factor indexes, namely selection, tilting and optimisation.  

Selection: keep it simple

The most straightforward approach in designing a factor index is to use a selection or elimination methodology, which circumscribes the starting universe based on stock factor characteristics.  This “in or out” operation is the defining feature of a selection strategy and can be thought analogous to the exclusion of alcohol, tobacco and other sin stocks due to social consideration. 

Selection strategies best succeed when pursuing specific mandates to which other portfolio concerns, such as turnover or tracking error, are clearly secondary—devising high dividend indexes is a prime example.  The FTSE Dividend Growth with Quality Overlay Index family, for instance, implements a series of selection screens, including the selection of companies in the top quartile for forward dividend yield, and the elimination of equities in the bottom 10% for quality z-score. This successive slicing and dicing of the starting universe excels in either capturing or excluding tail-end factor risks; often allocators are more concerned with extreme results or one-sided skews than the entire distribution of factor loads.

Factor Selection/Elimination

Chart illustrates the Selection eliminates low factor scores (i.e. bottom quintile) from the portfolio, overweighting the remainder

The challenge with selection, notwithstanding its transparency, is its lack of precision and efficiency.  While an investor can readily discern a stock is excluded because it is in the top 15% for richness of valuation, for example, how much difference is there between the 15th and 16th percentile for valuation? Selection will overweight the latter and zero-weight the former, when there is slight difference in factor scores. 

Absent further rules, selection will treat the 15th and 1st percentiles for valuation equally, even though there are vast differences in factor loads.  In other words, selection fails the commonsense proposition that likes should be treated alike, and non-likes should be treated disparately.

Tilting: unleveling the playing field

Moving from the most blunt to the most subtle of factor methodologies, tilting takes a starting universe (typically market cap) and reweights companies according to the intensity of their factor scores. There are many variations to tilt strategies, and indeed FTSE Russell operates two methodologies in this category. These tilt models include the legacy Fixed Tilt engine and the Target Exposure methodology, the latter of which dynamically reallocates based on factor intensity. 

Factor Tilt

This image illustrates Tilting leans in and out stocks in relation to their factor exposure—more factor, more weight

The most compelling feature of tilting is how the approach maintains fidelity to the benchmark, preserving the scope and purpose of the original asset class, while layering on factor premia. If in investor’s mandate includes minimising tracking error, the efficient use of active share will render tilt strategies quite attractive.  Indeed, FTSE Russell’s tilt methodologies feature factor scores as a direct bolt-on to market cap weights, before being renormalised by the gaussian error or exponential functions.

Best suited to low to moderate factor exposures, tilt indexes generally exhibit very high correlations to their starting universes (R stats of 0.95 or greater), and hence are popular in smart beta applications.  The factor combinations and intensities can be endless customised—the Russell 1000 2Qual/Val Index for instance simultaneously tilts to the quality and value factors in a two to one ratio.  Moreover, the proof is in the pudding; the fundamental portfolio characteristics shift in both directions—ROA increases while Price to Sales decreases.

Factor Indexes 101

  Selection Tilting Optimisation
Process subset portfolio by factor score Reweight by factor score Redefine opportunity set by factor score
Advantages Highly intuitive, can pursue aggressive solutions Preserves benchmark fidelity Leverages correlations and volatility
Disadvantages Inefficient use of active share Struggles going beyond moderate factor loads Non-intuitive, high dependence on past trading histories
Tracking Error High Low Moderate
Transparency Very High High Low
Common Uses Dividends strategies, eliminating tail end results Single, multifactor models Multifactor models, concentrated baskets
The key limitation to tilt-based strategies is they struggle with very high factor loads.  An allocator looking to make concentrated factor bets would look at the middle third of the index with roughly market cap weight as deadweight—why are large portions of my investment not expressing a factor view point? If a concentrated basket of 30 to 50 stocks is desired, then this is where optimization enters the equation.    

Optimisation: the 4-D chess approach

Whereas tilting begins with the benchmark and applies factor loads, optimization starts with the factor portfolio in mind and moves back towards the benchmark.  The killer app to optimisation is its ability to leverage cross asset correlations and volatility measures to identify the mathematically ideal portfolio—it is a line of best fit on steroids.  By unlocking these intra-asset efficiencies, optimisation can push the frontier of factor portfolios into truly creative territory, especially with aggressive multi-factor strategies.

This potential does come at a considerable cost.  Foremost, these complex mathematical models are effectively opaque to the uninitiated, and can deliver counter-intuitive results.  Let’s suppose two stocks score very highly on the desired factor scores and are strongly correlated as well—but the first exhibits a better risk reward profile than the second.  An optimiser will typically underweight the latter to free up allocation to heavily overweight the less volatile stock. 

Factor Optimisation

Image displays Optimization complexly weights individual stocks based on factors, correlations and volatility

This approach will see company pairs, such as Exxon and Chevron or Facebook and Google, receive disparate treatment even if their factor loads are similar. Alternatively, a low factor company can receive considerable weight if it is uncorrelated to the desired factor characteristics and provides diversification value, or if the stock helps replicate the benchmark.

What is optimal is not always desirable, as optimisation is guided by constraint and is heavily reliant on past performance.  When market conditions change, the highly calibrated model may be poorly positioned.  This is not to say that optimisation cannot generate powerful results, but the process of implementation can be confounding.

I guess there is a factor in all of us

At FTSE Russell, we work with clients to unlock the power of factors, navigating the tradeoffs of each construction method until we find a suitable solution.  Whether selection, tilting, optimisation or even a unique hybrid strategy, the real factor is leveraging the modern tools of finance to empower client investment objectives.  Calculating factors is a steadfast science, but their application remains a high concept artform.

Read more about

Stay updated

Subscribe to an email recap from:


© 2024 London Stock Exchange Group plc and its applicable group undertakings (“LSEG”). LSEG includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) FTSE Fixed Income Europe Limited (“FTSE FI Europe”), (5) FTSE Fixed Income LLC (“FTSE FI”), (6) FTSE (Beijing) Consulting Limited (“WOFE”) (7) Refinitiv Benchmark Services (UK) Limited (“RBSL”), (8) Refinitiv Limited (“RL”) and (9) Beyond Ratings S.A.S. (“BR”). All rights reserved.

FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, WOFE, RBSL, RL, and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “FTSE4Good®”, “ICB®”, “Refinitiv” , “Beyond Ratings®”, “WMR™” , “FR™” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of LSEG or their respective licensors and are owned, or used under licence, by FTSE, Russell, FTSE Canada, FTSE FI, FTSE FI Europe, WOFE, RBSL, RL or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator. Refinitiv Benchmark Services (UK) Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.

All information is provided for information purposes only. All information and data contained in this publication is obtained by LSEG, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical inaccuracy as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of LSEG nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or LSEG Products, or of results to be obtained from the use of LSEG products, including but not limited to indices, rates, data and analytics, or the fitness or suitability of the LSEG products for any particular purpose to which they might be put. The user of the information assumes the entire risk of any use it may make or permit to be made of the information.

No responsibility or liability can be accepted by any member of LSEG nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any inaccuracy (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of LSEG is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.

No member of LSEG nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this document should be taken as constituting financial or investment advice. No member of LSEG nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset or whether such investment creates any legal or compliance risks for the investor. A decision to invest in any such asset should not be made in reliance on any information herein. Indices and rates cannot be invested in directly. Inclusion of an asset in an index or rate is not a recommendation to buy, sell or hold that asset nor confirmation that any particular investor may lawfully buy, sell or hold the asset or an index or rate containing the asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index and/or rate returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index or rate inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index or rate was officially launched. However, back-tested data may reflect the application of the index or rate methodology with the benefit of hindsight, and the historic calculations of an index or rate may change from month to month based on revisions to the underlying economic data used in the calculation of the index or rate.

This document may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of LSEG nor their licensors assume any duty to and do not undertake to update forward-looking assessments.

No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of LSEG. Use and distribution of LSEG data requires a licence from LSEG and/or its licensors.