FTSE ActiveBeta Indices and ActiveBeta Portfolios have important applications within the overall equity investment process.

Investment Vehicles

Both the FTSE ActiveBeta Indices and ActiveBeta Portfolios offer a simple, transparent, and rules-based passive implementation of Momentum and Value strategies. The FTSE ActiveBeta Indices are market capitalization-weighted. They are investable, have nearly unlimited capacity, and can be implemented on an industry-wide basis. The methodology employed to rebalance the indices strives to strike an appropriate balance between frequent rebalancing needed to capture the returns associated with high turnover strategies, such as momentum, and keeping the implementation costs at a reasonable level. Therefore, these indices are ideally suited to form the basis for investment vehicles that provide a high-capacity, low-cost option for capturing independent Momentum and Value returns and the combined Momentum and Value diversification strategy returns. These vehicles represent a true passive alternative to traditional active management to capture the long-term return premia associated with Momentum and Value investing.

Passive Representation of the So-Called Growth Style

Many studies have shown that growth managers invest in high price momentum companies, not in high long-term earnings growth companies. Therefore, growth indices, whether defined in terms of a valuation ratio, such as book to price, or in terms of single or multiple earnings-growth related factors, do not appropriately depict the characteristics selection of active growth managers. Furthermore, high price momentum characteristics are known to generate positive active returns, while high long-term earnings growth characteristics typically deliver negative active returns in the long run. As such, when the performance of so-called growth managers is compared to the current growth indices or growth index-linked passive vehicles, they appear to perform well, primarily because of characteristics selection rather than stock selection.

We argue that, from a product structuring perspective, investment vehicles based on momentum indices, such as the FTSE ActiveBeta Indices, would constitute a more appropriate passive alternative to the so-called active growth style compared to the growth index-linked vehicles.

Portfolio Diversification

The above discussion also implies that portfolio structures based on the current value-growth style specification framework are potentially at a disadvantage as the growth selection universe used as a starting point to allocate to growth managers typically delivers negative active returns. Momentum is a more effective diversifier of value returns, as it independently delivers positive active returns in the long run.

The historical active risk and return characteristics of the Momentum and Value Index (MVI) clearly highlight the benefits of pursuing a Momentum and Value diversification strategy. However, since no global momentum indices have existed before ActiveBeta, asset owners have had no choice but to implement a Momentum and Value diversification strategy through active managers. In this regard, some asset owners diversify their allocations across a number of Momentum- and Value-oriented managers in an attempt to benefit from the risk reducing attributes of Momentum and Value active returns as well as to limit the individual manager business and investment process risk. However, implementing the Momentum and Value diversification strategy through active managers is clearly not an efficient option. Apart from the active management cost-related considerations, manager diversification also tends to cause alpha erosion. That is, the higher the number of active managers employed, the higher the likelihood that the overall active portfolio will end up generating market-like returns.

The MVI represents a passive alternative to implement a Momentum and Value diversification strategy at the overall portfolio level. A strategic allocation to MVI-like investment vehicles makes it possible for asset owners to create more efficient overall portfolio structures. The ease of implementation, low cost, and high capacity offered by the MVI implies that asset owners can significantly reduce the investment burden of employing a large number of managers, and allocate their management fee and active risk budgets more efficiently to the talented managers with true stock selection skill.

Portfolio Structuring

The above arguments lead us to recommend a three-component portfolio structure comprising of market selection, characteristics selection, and stock selection, as depicted below.

In this structure, market selection represents a market return capture implemented through passive replication of market and/or market size segment indices. Characteristics selection represents the capture of stock characteristics, such as Momentum and Value, which are known to be associated with positive long-term active returns. Since using active managers to capture characteristics-based returns is not desirable, characteristics selection should be implemented, on a strategic basis, through appropriate passive alternatives. Finally, stock selection represents individual manager skill that can only be implemented through active managers. However, asset owners should ensure that active managers are hired and compensated for skill, which goes beyond simple stock characteristics selection. This involves using appropriate benchmarks to evaluate active managers, such as a Momentum index to assess the skill of so-called growth managers.