I have recently begun authoring a monthly series on the performance of various factor tilts. I have shown that five buy-and-hold strategies - size, value, low volatility, dividend growth, and equal-weighting - have outperformed the market benchmark over long-time periods. A recent paper, What's In Your Benchmark? A Factor Analysis of Major Market Indexes from three Blackrock (BLK) researchers estimates the representation of long-only factors in commonly used equity market benchmarks. The authors used five popular factors to attribute returns - size, value, and volatility that I cover frequently - as well as momentum and quality that I have covered in past articles.
The authors - Andrew Ang, Ananth Madhavan, and Aleksander Sobczyk - utilized a methodology that measures factor exposures at the constituent level and builds factor replicating portfolios for each respective index by weighting the risk factors in a way that leads to the factor replicating portfolios having the same risk factor scores as the index under scope.
The trio estimated the long-only factor representation of major market indices, including the domestic S&P 500 (SPY), the Russell 1000 (IWB), the Russell 3000 (IWV), the Russell 1000 Growth (IWF), and Russell 1000 Value (IWD). Internationally, the authors built factor-mimicking portfolios for the MSCI World (URTH), the MSCI ACWI (ACWI), the MSCI ACWI and Frontier Markets, the MSCI EAFE (EFA), the MSCI EMU (EZU), and the MSCI Emerging Market Index (EEM). If you are scoring at home, that is a lot of iShares ETF's, a fund family owned by the parent company of the researchers.
The authors find that the factor exposures of indices are time-varying, but their observations at the end of 1Q17 are rather interesting. The S&P 500 came in at 47% quality, 27% value, and 26% momentum. As you would expect of this large-cap benchmark, there was no weight towards the size factor, but perhaps more surprisingly there was also no weight to the low volatility factor. This result suggests that there can be significant portfolio diversification added by included funds that focus on these factors to your portfolio. Domestic large-cap low volatility funds include the PowerShares S&P 500 Low Volatility ETF (SPLV) and iShares Edge Minimum Volatility USA ETF (USMV).
The Russell 1000 added a little bit of the size factor (14%). The Russell 3000 loaded on momentum (31%), value (23%), size (26%), and quality (20%). The Value index loaded largely on value (61%) and low volatility (34%), and the Growth Index loaded on momentum (50%) and quality (42%). Outside of the U.S., European stocks tended to load more on value. Emerging market stocks loaded on value and momentum.
With market indices loaded meaningfully on risk factor premiums, passive investors are effectively factor investors whether they understand it or not. With the prevalence of low-cost factor ETFs (including those offered by Blackrock), investors can now take more direct exposure to factor tilts instead of taking these exposures indirectly through the changing factor composition of capitalization-weighted benchmarks. Even when the underlying index constituents are different, these benchmarks may exhibit similar behavior, especially in a period of heightened market correlation. Understanding the factor exposures of different market benchmarks can ensure proper portfolio diversification and improve risk management.
My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I am/we are long SPY,USMV,SPLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.