Deploying Multi-Factor Index Allocations in Institutional Portfolios

This paper is the second in a three-paper series focusing on factor investing. In the first paper, “Foundations of Factor Investing”, we discussed six factors — Value, Low Size, Low Volatility, High Yield, Quality and Momentum — that historically have earned a premium over long periods, represent exposure to systematic sources of risk, and have strong theoretical foundations. We also discussed how they could be captured through indexation. In this paper, we turn to the question of how institutional investors interested in factor investing may allocate to and across factors. In particular, we introduce a new framework for how institutional investors might consider implementing factor allocations through a passive mandate replicating a single multi-factor index. We call this type of allocation a multi-factor index allocation. Multi-factor indexes combine select factor indexes into single mixes created and controlled by the investor. Multi-factor indexes historically have demonstrated four key benefits: diversification, transparency, cost-efficiency via reduced turnover, and flexibility