MSCI has launched new multi-factor indexes as a way for money managers to gain exposure through passive management to some performance factors in the market that could previously be obtained only through active management.

When it comes to factor-based investing, money managers around the world have asked some of the same questions:

* How does one capture factors via allocations to investable indexes?

* How should managers think of factor index-based approaches relative to traditional passive and active management?

The question of what drives stock returns has been a staple of modern finance. The oldest and most well-known model of stock returns is the Capital Asset Pricing Model, which became a foundation of modern financial theory in the 1960s. In the CAPM, securities have only two main drivers: systematic risk and idiosyncratic risk. Systematic risk arises from exposure to the market and is captured by a stock's beta to the market. Since systematic risk cannot be diversified away, investors are compensated with returns for bearing this risk.

Later, Ross (1976) proposed a different theory of what drives stock returns. "Arbitrage pricing theory" (APT) says that the expected return of a financial asset can be modeled as a function of various macroeconomic factors or theoretical market indexes. We can credit Ross with popularizing the original term "factors," as the models he popularized were called "multi-factor models." In general, a factor can be thought of as any characteristic relating a group of securities that is important in explaining their returns and risk.

There are three main categories of factors today: macroeconomic, statistical, and fundamental. Macroeconomic factors include measures such as surprises in inflation, surprises in GNP, surprises in the yield curve, and other measures of the macro economy. Statistical factor models identify factors using statistical techniques where the factors are not pre-specified in advance. Arguably the mostly widely used factors today are fundamental factors. Fundamental factors capture stock characteristics such as industry membership, country membership, valuation ratios, and technical indicators, to name a few. The most popular factors today - value, growth, size, momentum - have been studied for decades as part of the academic asset pricing literature. Barra (now an MSCI company) has undertaken the research of fundamental factors since the 1970s.

Empirical studies show that these factors have exhibited excess returns above the market. For instance, the seminal Fama and French (1992) study found that the average small cap portfolio (averaged across all sorted book-to-market portfolios) earned monthly returns of 1.47% in contrast to the average large cap portfolio's returns of 0.90% from July 1962 to December 1990. Similarly, the average high book-to-market portfolio (across all sorted size portfolios) earned 1.63% monthly returns compared to 0.64% for the average low book-to-market portfolios.

The original studies on factors were intended to identify which stock characteristics explained returns. The factor portfolios constructed by the academics in these studies were not designed for actual implementation. For instance, the Fama-French portfolios include all listed equities (in the US, listed on NYSE and AMEX) including many small illiquid names and are pure long/short portfolios with no accommodation to the size of short positions.

Over the last decade, index providers recognized that factors could be captured in transparent rules-based ways. Investors realized that factor strategies could outperform the market similar to their theoretical factor counterparts while having strong liquidity and investability characteristics.

Indexation has provided a powerful way for investors to access factors in cost-effective and transparent ways. Factor allocations can be implemented passively using factor indexes, which may bring potential cost savings. Factor indexes also bring transparency to factor allocations, which helps alleviate the well-known problem of manager style drift.

Because of these benefits, the use of passive funds based on factor indexes has received strong interest by institutional investors.

Factor index-based funds should not be viewed as replacements for traditional market cap-based funds but as complements. This is because the latter reflect both the opportunity set of investors as well as their aggregate holdings. Market capitalization weighted strategies are in fact the only reference for a truly passive, macro consistent, buy and hold investment strategy with low turnover, very high trading liquidity and extremely large investment capacity. While their objectives might be different from institutions, individual investors too have begun to recognize the potential benefits of factor-based approaches-strong historical performance, potential cost savings, and transparency.

To conclude, factor investing has skyrocketed in popularity in recent years. Over the long-term, factors have historically better performance than market capitalization weighted portfolios. Indexation is opening a new way for factor investing today by allowing investors to access factors through passive vehicles that replicate factor indexes. Formerly, exposure to these factors could only be obtained only through active management. This revolution in the industry now allows investors even greater flexibility and control in the way they can achieve their return and risk performance objectives.

Diana Tidd is managing director and head of the MSCI Index Business for the Americas and Remy Briand is managing director and global head of index and ESG Research at MSCI.

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