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Factors Strategies: Avoiding Off-Target Exposure Pitfalls

by: FTSE Russell
Summary

Factor investing is no longer a niche strategy frequently applied by the sophisticated few.

These strategies' potential for improved risk-adjusted returns has led to successful long-term relationships with pension funds and a growing demand from retail clients.

Off-target exposures can also be an unintended consequence of portfolio construction.

By Alexandros Severis, Smart Beta Product Manager

Factor investing is no longer a niche strategy frequently applied by the sophisticated few. These strategies' potential for improved risk-adjusted returns has led to successful long-term relationships with pension funds and a growing demand from retail clients.

A common issue is that investors frequently feel that they lose control or are led astray by the promises of factor strategies relative to actual outcome. The problem: unintended factor exposures created as a result of index construction and factor correlations.

For example, let's consider a multi-factor portfolio constructed using a traditional tilt framework with the aim of achieving specific fixed exposures to the Value and Quality factors. The chart below (Chart 1) shows that, despite incorporating Value and Quality tilts and ignoring Momentum, factor correlation unintendedly led to an unwanted negative exposure to the Momentum factor (Chart 2). This unwanted exposure is called off-target exposure.

Source: FTSE Russell. Data based on the FTSE Developed Universe and Value factor scores from September 2000 to September 2019. Please see the end for important legal disclosures.

Given that factors are associated with positive long-term risk-adjusted returns, a systematic negative exposure to a factor could have a detrimental effect on portfolio performance and lead to implementation shortfall. One solution to this is to incorporate corrective tilts, which may tilt towards or away from specific factors in order to neutralize the unwanted factor exposure (Charts below).

Source: FTSE Russell. Data based on the FTSE Developed Universe and Value factor scores from September 2000 to September 2019. Please see the end for important legal disclosures.

Off-target exposures can also be an unintended consequence of portfolio construction. In order to illustrate this, (charts below) we constructed three semi-annually rebalanced Quality portfolios using the FTSE Developed Index as the investment universe.

  • First, we constructed a Selection and Weighting (S&W) portfolio. Selecting the highest ranked stocks by Quality score and equal weighting the constituents within the portfolio. The proportion of the universe chosen is such that the resulting portfolio has unit active Quality exposure.
  • We then created a Quality Tilt portfolio. This portfolio had a single tilt towards Quality whereby the tilt strength selected is based on the level of desired active quality exposure.
  • The third portfolio, the Pure Quality portfolio, was constructed using the target exposure mechanism in order to achieve unit active exposure to Quality but avoid any off-target exposures, while also ensuring market beta, country and industry neutrality.

The resulting average active factor exposures and average (absolute) active country and industry weights of each portfolio can be seen below.

Source: FTSE Russell. Data based on the FTSE Developed Index Universe at rebalance from September 2000 to September 2019. Indexes were developed for research purposes only. Please see the end for important legal disclosures

The S&W portfolio displays the largest off-target style exposures. We see a significant Size factor exposure, despite being a Quality index. This is a result of its equal weighting methodology. The Quality Tilt portfolio has significantly less off-target exposure mainly in the form of Beta, whilst the Pure Quality portfolio has almost no off-target exposures.

Using the tilt methodology for portfolio construction has proven to be an effective method in terms of targeting factor exposure and limiting off-target exposure. Target exposures are achieved by actively tilting towards them: off-target attributes that are not actively tilted towards tend to be relatively small. Moreover, the pure quality portfolio has no active sector and industry weights unlike the S&W portfolio, which assumes the largest country and industry bets. Such unwanted active bets lead to a major source of active risk.

Percentage Contribution to Active Risk

Source: FTSE Russell. Data based on the FTSE Developed Index Universe from September 2000 to September 2019. Indexes were developed for research purposes only. Please see the end for important legal disclosures.

The Pure Quality portfolio has a series of corrective tilts applied in order to remove unwanted exposures. All sources of active risk with the exceptions of the targeted factor and stock specific residual risk are removed. This results in lower levels of tracking error. The performance of pure factor indexes is therefore more closely aligned with the stated investment objectives. One further advantage of using corrective tilts with the Target exposure approach is that they are not necessarily confined to factors. They can be used to achieve market, industry and country neutrality or even control the exposure to specific climate or ESG characteristics.

The Target Exposure approach is an evolution of the current tilt methodology. It builds on the powerful factor story while ensuring that greater control and flexibility lays in the hands of the investors.

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