“Is there a way to refine an index, focusing on stocks likely to add extra return within my chosen investment paradigm?”
Indices are a means of grouping together securities with similar characteristics. Whether broad groups, like the “World equity universe,” or extremely narrow ones, like “Swiss technology mid-cap equities,” they offer index investors a way to concentrate on preferred investment themes.
Almost all indices are compiled using a market-capitalization weighted basket of all relevant titles. Their collective performance, indicative of that market as a whole, is known as “market beta.”
While this is common practice, index investors might ask themselves if there are ways of refining such indices to enhance potential returns beyond that of the market average.
The answer is yes.
A matter of factor
Factor investing, also known as “smart beta” or “alternative beta,” is an investment approach that focuses on various characteristics of securities beyond market-capitalization, region or sector. While it has received a lot of attention lately among investors and the media, it is hardly new – academic research into factor investing began in the 1970s and continues to this day.
As a result of this research we have extremely strong evidence that certain factors, in particular “value,” “low volatility”, “quality,” and “yield,” all outperform the broader market over the long run.* Constructing indices with such factors in mind may therefore help index investors enhance returns. That said, while the above-mentioned factors have consistently outperformed, they do have their own cycles. That makes diversification as important in factor investing as it is in any other investing.
So what are these factors? Value. Volatility. Quality. Yield.
*Harvesting Risk Premia with Strategy Indices, September, 2011