Applications of Systematic Indexes in the Investment Process
Authors: Dimitris Melas, Xiaowei Kang
Source: Journal of Indexes
Date: September/October 2010
In asset management, it is now widely recognised that many sources of risk other than that represented by the market portfolio can generate systematic returns. As cap-weighted indexes serve only to capture market risk, many indexes have recently been developed to capture other risk factors. All of these indexes rely on weighting schemes other than the well known capitalisation weighting suggested by portfolio theory. In this article, Melas and Kang choose to focus on so-called “systematic indexes”, indexes that capture systematic risk factors, and on the ways they can be used, for both strategic and tactical asset allocation, in portfolio management.
The authors first introduce the main factors that explain portfolio returns, including country, industry, and style factors. They find that, over their two observation periods—from January 1997 to June 2002 and from July 2002 to June 2008—volatility, momentum, size, and value were the most influential of the factors they introduce. Second, they describe how to develop indexes that capture those factors. Indeed, many new indexation methods, such as equally weighted portfolios, risk-weighted portfolios or minimum-variance portfolios, can be seen as special cases of mean-variance portfolio optimisation. Thus, they argue that mean-variance optimisation can serve to design factor portfolios mimicking any systematic factor, such as momentum, liquidity, leverage, and so on.
A simple proxy is obtained for a factor portfolio by selecting the optimal mean-variance portfolio with an expected return equal to the factor’s exposure. The result is a simple factor portfolio. It is also possible to improve this method by taking into account not only expected return but also expected volatility and correlations. This technique, which requires general mean-variance optimisation, produces pure factor portfolios. The term pure indicates that it replicates a specific factor, while eliminating exposure to all other factors. Portfolio risk can thus be minimised (see Melas, Suryanarayanan, and Canaglia, 2010, for a description of the methods that can be used to produce pure factor portfolios).
The authors then present the practical applications of these systematic indexes in portfolio management, first for strategic asset allocation, and second for tactical asset allocation. Adding factor overlays to a core equity portfolio, it is possible to tilt the portfolio away from factors generating negative returns and towards those generating positive returns. The use of factor indices can also serve to adjust portfolio risk downwards or to improve risk-adjusted returns. Minimum-volatility indexes are usually used for the latter. These strategies can be used in both the strategic and the tactical phases of managing the portfolio; in other words, to adjust long-term risk exposure or to act on short-term views.
Finally, the authors conclude that systematic indexes are a complement to market-cap indexes, as they provide additional tools for institutional investors to implement their strategic and tactical asset allocation. The benefits are risk reduction and improvement of risk-adjusted performance.
Melas, D., R. Suryanarayanan, and S. Cavaglia. 2010. Efficient replication of factor returns. Journal of Portfolio Management 36 (2): 39-51.