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Factors driving equity returns

As the prominence of “smart beta” in the index investing landscape has grown, many market observers are using the single term “smart beta” to describe both alternatively weighted and factor indexes. These are in fact two distinct categories of benchmarks, and FTSE believes that it is helpful to distinguish between them.

The primary difference lies in the index objective. Alternatively weighted indexes may have diverse objectives, while factor indexes are typically more singularly focused. More specifically, factor weighted indexes focus on the “factors” that are believed to drive securities’ returns In essence, a factor helps explain equities’ behavior.

As modern finance theorists have sought to explain equity returns, two of the most influential models built with this objective are factor-based. The single factor Capital Asset Pricing Model (CAPM) and the multi-factor Fama-French model both seek to answer the fundamental question of what drives equity returns. 

In aggregate, these models point to four primary factors that can affect equity performance. These include the overall market return, size value and momentum. The models are supported by empirical evidence suggesting these factors play a significant role in explaining equity returns.

While the reason behind factor-based returns is still up for debate, investment professionals have nonetheless recognized their existence. As such, factors and factor indexes have been increasingly incorporated into investment processes.

As the first major index provider to offer non cap-weighted indexes, FTSE has developed the FTSE Global Factor Index Series, designed to represent the performance of specific factor characteristics. The indexes are based on the FTSE Developed and FTSE Emerging indexes and consist of six single factor indexes, including liquidity, momentum, quality, size, value and volatility.

 

FTSE’s Equity Factor Framework

Source: FTSE, as at September 2014.

 

 

 

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