Asset owners use indexes as policy benchmarks and reference portfolios in their asset allocation. Index investors track cap-weighted indexes that seek to capture the market return. Active investors select securities and build portfolios that aim to outperform the market. All of these types of investors may be able to benefit from incorporating factors into their process but, more importantly, integrate factors without compromising other fundamentally important aspects of their strategies
The research paper Beyond market equilibrium – The future of active investing reviews factor performance in global equity markets using coherent data and methodology, and applies a new template to evaluate backtests for potential selection bias under multiple testing. The paper proposes a systematic process for integrating factor information into different investment strategies, demonstrating that this process is consistent with the Black-Litterman framework, and tests it on a sample of market indexes and active equity portfolios.
The paper found that integrating factors in indexes improves risk-adjusted performance while retaining high liquidity and capacity, and that adding factors to active strategies enhances information ratios while maintaining the portfolio characteristics and stock selection alpha of the original strategies.
MSCI’s review of factor performance in global equity markets and the systematic process for integrating factor information into different investment strategies can have important implications for different types of investors:
- Asset owners may be able to tilt reference indexes towards rewarded factors without sacrificing market coverage and diversification
- Index managers can track factor-tilted indexes as they remain investable and replicable
- Active managers may be able to incorporate factor information into their strategies to harvest factor premia while preserving their core investment process and the added value from fundamental security selection.