Factor Indices: A Simple Compendium

INTRODUCTION

Passive management has become so prominent in the investing landscape that we sometimes forget that the entire history of index funds spans only 50 years. Indices, of course, have a more extensive pedigree than index funds, having been developed initially simply as a means of summarizing the returns of a given stock market. As such, it was natural for at least some observers to compare the returns of actively managed portfolios to index returns, thus using indices as benchmarks for portfolio management.  It was the observation that many (nay, most) professional investment managers routinely underperformed index benchmarks that led to the creation of the first index funds, i.e., to the use of indices as investment vehicles.

The first generation of index funds was designed to replicate an asset class; for example, the S&P 500^® is the most common representative of large-capitalization U.S. stocks.  But not all active managers can be usefully evaluated by comparing them to large-capitalization U.S. stocks; specialist mandates (perhaps emphasizing value, or small size, or low volatility) are common among investment managers, and indices have evolved in order to provide appropriate benchmarking.  Factor indices—understanding a “factor” as an attribute with which excess returns are associated—are a prime example of this trend. 

Factor indices can help the clients of specialist managers disentangle how much of the manager’s performance is attributable simply to factor exposure, and how much is attributable to the manager’s stock selection beyond the factor.  Like their first-generation counterparts, factor indices can be used as both benchmarks and investment vehicles.  In the latter use, we can speak of “indicizing” a factor or set of factors—i.e., delivering in passive form a strategy formerly available only via active management.