Ted Stover, Managing Director, Research and Analytics December 2014 FactOR Fiction?
Important Legal Information FTSE is not an investment firm and this presentation is not advice about any investment activity. None of the information in this presentation or reference to a FTSE index constitutes an offer to buy or sell, or a promotion of, a security. This presentation is solely for informational purposes. Accordingly, nothing contained in this presentation is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of making any investment through our indexes Page 2 FTSE Factor Exposure Indices
What is Smart Beta? Page 3 Presentation Title
What is Smart Beta? Smart Beta is a controversial phrase used mainly by marketers and media to describe a wide variety of approaches to constructing indexes. Creating a lot of confusion and disagreement. Key question: What is the index objective? Page 4
Let s avoid this confusing phrase and introduce two concepts 1. Alternatively Weighted Indices Non market capitalization weights Variety of methodologies Specific index level objectives: e.g. diversification, volatility reduction Broad, diversified market exposures Incidental or uncontrolled factor exposures Minimum Variance: No explicit return objective in contrast to Low Volatility Factor Index: Factor return is an inverse function of volatility Page 5
Let s avoid this confusing phrase and introduce two concepts 2. Factor Indices Confusion Objective explicitly targets factors Market capitalization or alternatively weighted Tool for measuring factor performance Deliberate factor tilts controlled factor exposure is the intention Alternatively Weighted Indices are used to obtain factor exposures, both described as Smart Beta Page 6
So What are Factors? A persistent stock level characteristic Can help explain the return behavior of a security Systemic and non diversifiable Significant body of academic support Long term risk premium? Used in active management for decades E.g. Value, Momentum, Size, Low Volatility Page 7
Why is Interest Growing? Page 8 Presentation Title
Information Tool Investment Tool Evolution of Indices A means of measuring risk premia Tool for assessing market risk and diversification benefits Smart Beta Indices Indices now cover all asset classes, from real estate to infrastructure Underlying component of financial products From passive tracker funds, structured products and derivatives to ETFs Economic Indicator Tool for benchmarking Performance analysis for active managers. Shift from peer group comparison to index benchmarks The evolution of indexing over time Page 9
Reason for the Appeal of Alternatively Weighted Indices Move from active to passive management Passively managed assets estimated to grow to $22.2 Trillion by 2020* Global adoption: Smart Beta ETF assets in Europe estimated to double by 2017** to c. 9 Billion Increased emphasis on cost efficiency and transparency Substantial evidence that the majority of active managers do not consistently outperform benchmarks Perceptions of market cap weighted indexes Academics question the efficiency of market cap weighted indexes Prone to episodic periods of extreme concentration and perceptions of misallocation Need for low cost passive mechanisms to do more to meet specific factor and non factor objectives Index providers like FTSE have increased their efforts to provide effective, transparent and low cost index solutions * Source: PWC, Asset Management 2020: A Brave New World, 2014 ** Source, Invesco PowerShares, Index Investing and Smart Beta in Europe, 2014 Page 10
% Weight Index Weight of Technology in FTSE Developed Index 30% 25% 20% 15% 10% 5% 0% Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Page 11 Source: FTSE Group. Data as at October 2014. Past performance is no guarantee of future results. See final slide for legal disclosures.
Reason for the Appeal of Factor Indices Asset Allocation Traditionally, asset allocation used to capture asset class risk premia New approaches are enhancing replicability with focus on implementation, liquidity and capacity Risk Premia Factors represent an additional source of risk premia within an asset class Factors can be captured in a systematic and low cost manner Factor diversification may be more effective than asset class diversification* Strategic Perspective Factor returns are a long run phenomenon and can be cyclical Facilitates risk and factor exposure control Key question: is the factor likely to persist? Page 12 *The Death of Diversification has Been Greatly Exaggerated - Ilmanen & Kizer JPM Summer 2012
Which Factors? Factor Illiquidity Definition Amihud Ratio- median absolute daily return relative to daily traded value over last year Momentum Residual Sharpe Ratio Quality Composite of Profitability (ROA), Efficiency (ATO), Earnings Quality (Accruals) & Leverage Size Full Market Capitalization Value Volatility Composite of trailing Cash-flow Yield, Earnings Yield & country relative Sales to Price Standard Deviation of 5 years of weekly (Wed/Wed) local total returns Academic and practitioner consensus on persistent effects Significant body of evidence across geographies and time periods No consensus over the source(s) of factor premia Require effects to persist in the long run Page 13 FTSE Factor Exposure Indices
Factor Exposures in Alternatively Weighted Indices Page 14 Presentation Title
Targeting Specific Index Level Objectives, Not Factor Exposure Index Type Objective Example Notes Fundamental Dynamic Value FTSE RAFI Select and weight by measures of economic size Correlated with, but independent of, market measures of size Value tilt is an uncontrolled effect of the constituent selection and weighting process GDP Weighted Diversification FTSE GDP Weighted Size tilt is an uncontrolled effect of weighting countries by GDP, increasing emerging market exposure Equally Weighted Diversification FTSE 100 Equally Weighted No return consideration Size and value tilts are an uncontrolled effect of weighting all constituents equally Minimum Variance Volatility Reduction FTSE Global Minimum Variance No explicit return objective Defensive / low volatility tilt and size tilts Incidental low volatility exposure is an uncontrolled effect of constituent selection process Equal Risk Contribution Diversification FTSE Global Equal Risk Contribution No return consideration Tilts are an uncontrolled effect of weighting risk across all constituents equally According to some academic studies, over the last 20 years, most alternative weighting schemes exhibited improved risk adjusted outcomes* Page 15 * Cass Consulting, Cass Business School Report, Evaluation of Alternative Equity Indices, 2013. The Surprising Alpha From Malkiel s Monkey and Upside Down Strategies, Arnott et al, JPM 2013
Factor Exposures in Alternatively Weighted Indices Alternatively Weighted Indices may have factor exposures, but they are rarely consistent or predictable Relative Exposure to Size Relative Exposure to Value 2 1.5 1 0.5 0-0.5 0.6 0.5 0.4 0.3 0.2 0.1 0-0.1-0.2 Equal Weight FTSE RAFI Dev. 1000 Equal Weight FTSE RAFI Dev. 1000 Fundamental Index (FTSE RAFI) shows very similar exposure to Size as underlying FTSE Developed Index Equal Weight Index has a consistently greater exposure to Size factor (small caps) Equal Weight Index shows a volatile exposure to Value factor over time, relative to FTSE Developed Fundamental Index (FTSE RAFI) consistently greater exposure to Value than FTSE Developed Index, but exposure varies widely Page 16 Source: FTSE Group. Data as at 31 October. 2014. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Factor Exposures in Alternatively Weighted Indices Alternatively Weighted Indices may have factor exposures, but they are rarely consistent or predictable 0.6 Relative Exposure to Illiquidity 0.6 Relative Exposure to Volatility 0.5 0.4 0.4 0.3 0.2 0.1 0 0.2 0-0.2-0.4-0.1-0.6 Equal Weight FTSE RAF Dev. 1000 EDHEC Equal Weight Equal Risk Min Var Equal Weight Index shows a relatively stable exposure to Illiquidity, consistently higher than the underlying FTSE Developed Index Fundamental Index has a variable exposure to Illiquidity Minimum Variance Index shows a increased exposure to Volatility factor, relative to FTSE Developed Index Other alternatively weighted indexes show no consistent trends in exposure to Volatility Page 17 Source: FTSE Group. Data as at 31 October. 2014. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Factor Exposures in Alternatively Weighted Indices Factor exposures in Alternatively Weighted indexes are an unintended consequence of the index construction process Factor exposures in Alternatively Weighted indexes are often volatile and unpredictable Even in cases where factor exposures exhibit greater stability, Alternatively Weighted Indices may not represent the optimal factor capture Page 18
Factor Indices Page 19 Presentation Title
Factor Indices Systematic capture of long-run factor premiums Intentional and controlled factor tilts: an objective of index design choices Mechanism to achieve single and multi-factor exposure Are composite indices meaningful? E.g. Value + Momentum A transparent, systematic approach is required Confusion as alternatively weighted indexes used to gain factor exposure Controlled Factor exposure is the primary objective unlike: Minimum Variance incidental size and low volatility exposure Equally Weighted varying size and value exposure Fundamental dynamic value exposure Page 20
Factor Exposures in Factor Indices Pure Factor indexes can capture a factor more effectively and consistently Relative Exposure to Size Relative Exposure to Value 2 1.5 1 0.5 0-0.5 1.2 1 0.8 0.6 0.4 0.2 0-0.2 Equal Weight Size Factor Index FTSE RAFI Dev Equal Weight FTSE RAFI Dev Value Factor Index Size Factor Index provides a consistently greater exposure to Size Factor then either equal weight, fundamental weight or market cap. Value Factor Index provides a consistently greater exposure to Value Factor than either equal weight, fundamental or market cap. Page 21 Source: FTSE Group. Data as at 31 October. 2014. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Factor Exposures in Factor Indices Pure Factor indexes can capture a factor more effectively and consistently Relative Exposure to Volatility 0.8 0.6 0.4 0.2 0-0.2-0.4-0.6-0.8 sep-00 sep-01 sep-02 sep-03 sep-04 sep-05 sep-06 sep-07 sep-08 sep-09 sep-10 sep-11 sep-12 sep-13 EHDEC Equal Weight Equal Risk Min Var Volatility Factor Index Volatility Factor Index provides a consistently greater exposure to Volatility Factor than all other weighting approaches, including risk-based indexes and Minimum Variance. Page 22 Source: FTSE Group. Data as at 31 October. 2014. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Capturing Factors Page 23 Presentation Title
Our Approach FTSE Factor Indices General approach; reweight (any) underlying index to achieve factor objective(s) Focus on implementation efficiency and flexibility Efficient signal capture Transparency Incorporate multiple factor objectives Overlay on any underlying index structure Capacity, replicability and diversification considerations Results in factor outcomes that are not confused with other objectives Page 24
Tilting and Re-Weighting Overlaying Factors on an Underlying Index Transparent general methodology; applicable to factors, themes and composite factors Re-weight constituents according to factor score higher score, higher weight Underlying index is typically capitalization weighted Methodology can also be applied to other weighting approaches Scoring and Weighting Normalize factor scores and truncate extremes (= Z Scores) Map Z Scores 0-1 Mapped scores are combined with underlying index weights Mechanism avoids concentrated outcomes in outlying stocks with extreme Z Scores Maintains broad market exposure unlike a ranking approach which selects only a subsection of securities Page 25
Value Exposure Tilting Improves Factor Exposure Tilting offers a consistently greater exposure to factors compared to a ranking approach FTSE Developed: Earnings Yield Exposure (Value) 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 09/2003 09/2004 09/2005 09/2006 09/2007 09/2008 09/2009 09/2010 09/2011 09/2012 09/2013 Tilt Rank Page 26 Source: FTSE Group. Data as at Sep. 2013. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Strength and Direction Changing Direction of Factor Tilt Long or short exposure to a factor can be achieved by reversing the sign on the Z-Score e.g. Low Momentum Index / High Momentum Index Express long/short views on factors in long only context Changing Strength of Factor Tilt Change mapping parameters, narrow index or Use multiple tilts: e.g. Tilt underlying index towards Momentum Consider this Momentum index as a new underlying Tilt new underlying towards Momentum again Can re-tilt towards same factor or multiple different factors Page 27
Value Loading Turnover Controlling the Strength of the Factor Exposure Controlling the strength of the factor exposure Balance factor exposure / capacity / turnover 2.3 2.1 1.9 1.7 190.0 180.0 170.0 160.0 Tilting twice results in high factor capture with improvements to both turnover and capacity relative to a narrower index. 1.5 1.3 1.1 150.0 140.0 130.0 0.9 120.0 0.7 110.0 0.5 Tilt With StDev = 1.0 Tilt With StDev = 0.5 Tilt with StDev = 0.1 Tilt - Tilt 100.0 Capacity (WCR) Value Loading Two Way Turnover (%) Page 28 Source: FTSE Group. Data as at Sep. 2013. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Multiple Factors Composite Indices, Composite Factors & Multiple Tilts Several possible approaches to achieving composite factor exposure: Composite Index: Equal weight multiple factor sub-indices Ranking: Combining individual factor Z-Scores to create a composite Z-Score. Rank and weight according to composite score Tilt-Tilt: Multiple, sequential tilts on each factor Last approach provides greater control Composite and ranking approaches may result in offsetting exposures Composite factor approach suitable for positively correlated factors. Not efficient at capturing negatively correlated factors Sequential tilt ensures exposure to all factors, including negatively correlated factors Page 29
Negatively Correlated Factors Combining (Negatively 0.6 Correlated) Factors Composite and ranking approach unsuitable: 0.5 one factor can cancel out the other 0.4 Multiple tilts result in a genuine 0.3 two factor index: double the 0.2 exposure 0.1 Similar to double sorting; identify stocks displaying both characteristics 0 Earnings Yield 12M Momentum Composite Factor Tilt-Tilt -0.1 Value Exposure Momentum Exposure Page 30 Source: FTSE Group. Data as at Sep. 2013. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Implementation Page 31 Presentation Title
Implementation Broad and Narrow Factor Indices Factor indices should be representative and manage replication challenges Offer suitable capacity Reduce concentration in individual countries or industry sectors / maintain broad exposure Be liquid, tradable and relatively inexpensive to replicate Tilting results in a broad index containing all underlying index constituents Narrowing the index may help reduce implementation costs, at the expense of some capacity Simple narrowing process: remove the stocks which contribute less to factor exposure Filter by weight or factor score Maintain diversification and capacity constraints Page 32
Value Exposure Implementation: Broad and Narrow Indexes FTSE Developed Broad Factor Index Narrow Factor Index Volatility (% p.a.) 17.14 17.47 17.78 Volatility Reduction (% p.a.) -1.90-3.73 Sharpe Ratio 0.10 0.19 0.17 Draw Down (%) -58.95-59.40-59.60 Two Way Turnover (% p.a.) 106.20 128.06 Excess Return (% p.a.) 1.58 1.30 Tracking Error (% p.a.) 2.09 2.39 Information Ratio 0.76 0.54 Beta 1.01 1.03 Average No. of Stocks 1940 1940 763 Capacity (WCR) 1.00 1.30 1.48 1.6 1.4 1.2 1 0.8 Narrowing the index can improve factor exposure Reduction in capacity 0.6 0.4 Approx. ½ the constituents of the broader index 0.2 Capacity constraints can be applied Broad Index Narrow Index Page 33 Source: FTSE Group. Data as at 30 Sep. 2013. Past performance is no guarantee of future results. Returns shown reflect hypothetical historical performance. See final slide for legal disclosures.
Illiquidity Exposure Implementation: Rebalancing Matters: Illiquidity 0.6 0.4 0.2 0.0-0.2-0.4-0.6-0.8 09/2001 09/2002 09/2003 09/2004 09/2005 09/2006 09/2007 09/2008 09/2009 09/2010 09/2011 09/2012 09/2013 FTSE Developed Broad(Monthly) Broad(Semi Annual ) Broad(Annual) Narrow(Monthly) Narrow(Semi Annual) Narrow(Annual) Exposure to Illiquidity is slow to degrade, so no advantage from more frequent rebalancing Narrowing the index has more impact on factor exposure than rebalancing frequency Risk adjusted outcomes and turnover insensitive to rebalance timing Page 34 Source: FTSE Group. Data as at Sep. 2013. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Momentum Exposure Implementation: Rebalancing Matters: Momentum 1.2 1.0 0.8 0.6 0.4 0.2 0.0-0.2-0.4 03/2001 03/2002 03/2003 03/2004 03/2005 03/2006 03/2007 03/2008 03/2009 03/2010 03/2011 03/2012 03/2013 FTSE Developed Broad (Monthly) Broad(Semi Annual) Narrow (Monthly) Narrow(Annual) Rapid exposure degradation narrow annually rebalanced or broad semi-annually rebalanced index? Narrow annual suffers rapid exposure decay; Semi-annual, a superior means of maintaining exposure Similar average, but more stable exposure Lower turnover, higher capacity & diversification Page 35 Source: FTSE Group. Data as at Sept. 2013. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance. See final slide for legal disclosures.
Conclusions Page 36 Presentation Title
Conclusions Factor and Alternatively Weighted Indices are designed to do different things: Alternatively Weighted Indices Index level objectives Broad adoption Unintentional factor exposures Factor Indices Specific factor targeting Long / short / leveraged or any weighting scheme Tools for measuring factor performance, tactically altering factor exposures Construction matters, especially for multi-factor indexes Know your benchmark and be smart about Smart Beta Page 37
Appendix: Performance Page 38 Presentation Title
Developed Factor Index Performance 110 Relative to FTSE Developed Index (USD) 105 100 95 90 nov-2009 nov-2010 nov-2011 nov-2012 nov-2013 nov-2014 FTSE Developed Illiquidity Factor FTSE Developed Momentum Factor FTSE Developed Quality Factor FTSE Developed Size Factor FTSE Developed Value Factor FTSE Developed Volatility Factor FTSE Developed Factor Index Return 3M % Return YTD % Return 12M % Return 5Yr % Volatility 1Yr % Volatility 3Yr % Volatility 5Yr % Illiquidity -2.3 4.1 6.5 69.9 9.4 13.7 16.8 Momentum -0.1 6.8 8.9 77.7 9.0 11.9 14.2 Quality 1.3 8.1 10.5 76.2 8.5 11.7 13.3 Size -3.5 4.0 6.0 74.7 8.0 12.9 15.4 Value -2.8 4.5 6.6 62.3 8.2 13.6 15.7 Volatility 2.0 10.8 12.7 83.6 7.9 10.3 12.2 FTSE Developed -0.3 6.8 9.0 71.3 8.5 12.2 14.4 Page 39 Presentation Source: FTSE Group. Title Data as at 28 November 2014. Past performance is no guarantee of future results. Returns shown reflect hypothetical historical performance. See final slide for legal disclosures.
Developed Factor Index Characteristics FTSE Developed Factor Index # Constituents Dividend Yield % Average Constituent Weights % Largest Constituent Weight % Median Constituent Weight % Top 10 Holdings Weight % Illiquidity 1157 2.27 0.09 0.65 0.07 4.78 Momentum 1666 2.18 0.06 1.51 0.02 9.59 Quality 952 2.22 0.11 4.03 0.04 16.89 Size 1448 2.07 0.07 0.23 0.06 2.04 Value 1357 2.75 0.07 2.32 0.02 15.56 Volatility 667 2.63 0.15 2.48 0.07 14.42 FTSE Developed 2113 2.31 0.05 2.01 0.02 9.28 Page 40 Presentation Source: FTSE Group. Title Data as at 28 November. 2014. Past performance is no guarantee of future results. Returns shown reflect hypothetical historical performance. See final slide for legal disclosures.
Emerging Factor Index Performance 120 Relative to FTSE Emerging Index (USD) 115 110 105 100 95 90 nov-2009 nov-2010 nov-2011 nov-2012 nov-2013 nov-2014 FTSE Emerging Illiquidity Factor FTSE Emerging Momentum Factor FTSE Emerging Quality Factor FTSE Emerging Size Factor FTSE Emerging Value Factor FTSE Emerging Volatility Factor FTSE Emerging Factor Index Return 3M Return YTD Return 12 M Return 5Yr Volatility 1Yr Volatility 3Yr Volatility 5 Yr Illiquidity -6.0 3.1 1.6 40.2 10.8 14.6 18.0 Momentum -6.9 5.8 4.9 28.7 11.0 15.3 18.0 Quality -6.7 6.3 5.2 27.4 10.5 15.2 17.2 Size -3.4 8.9 8.0 40.6 9.5 14.9 18.6 Value -7.6 5.2 2.3 12.6 12.1 17.6 20.3 Volatility -4.7 6.6 5.8 38.6 10.5 14.4 16.7 FTSE Emerging -5.8 6.6 5.2 21.4 10.7 15.7 18.3 Page 41 Presentation Source: FTSE Group. Title Data as at 28 November. 2014. Past performance is no guarantee of future results. Returns shown reflect hypothetical historical performance. See final slide for legal disclosures.
Emerging Factor Index Characteristics FTSE Emerging Factor Index # Constituents Dividend Yield % Average Constituent Weights % Largest Constituent Weight % Median Constituent Weight % Top 10 Holdings Weight % Illiquidity 558 3.06 0.18 1.76 0.14 9.63 Momentum 844 2.66 0.12 3.52 0.05 18.03 Quality 611 3.14 0.16 5.96 0.05 24.64 Size 610 2.82 0.16 0.66 0.14 5.26 Value 660 3.68 0.15 4.25 0.05 25.58 Volatility 341 3.16 0.29 5.78 0.15 23.94 FTSE Emerging 905 2.94 0.11 3.14 0.05 15.85 Page 42 Presentation Source: FTSE Group. Title Data as at 28 November. 2014. Past performance is no guarantee of future results. Returns shown reflect hypothetical historical performance. See final slide for legal disclosures.
Information Ted Stover Managing Director, Research & Analytics Email: Ted.Stover@ftse.com Methodology Summary http://www.ftse.com/products/downloads/ftse_index_construction_methodology_paper.pdf Value http://www.ftse.com/products/downloads/ftse_value_factor_paper.pdf Momentum http://www.ftse.com/products/downloads/ftse_momentum_factor_paper.pdf Quality http://www.ftse.com/products/downloads/ftse_quality_factor_paper.pdf Disclaimer FTSE is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited ( FTSE ) under licence. All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by FTSE or its licensors for any errors or for any loss from use of this publication. Neither FTSE nor any of its licensors makes any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE indexes or the fitness or suitability of the FTSE indexes for any particular purpose to which they might be put. FTSE does not provide investment advice and nothing in this presentation should be taken as constituting financial or investment advice. FTSE makes no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indices cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. 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 FTSE. Distribution of FTSE index values and the use of FTSE indexes to create financial products requires a licence with FTSE and/or its licensors. Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Certain index returns shown do 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 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 was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.. Page 43