A Guide to Equity Index Construction (2nd Edition)
First published:
ISBN: 9781782724483
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Factor indices and smart beta
Factor indices and smart beta
Preface
Acknowledgements
Introduction
Which benchmark?
Modern portfolio theory and the benchmark index
Sampling and selection
Construction method
Making the index investable
Collection and processing of data
Servicing and maintenance
How to handle industries
How to handle countries and currencies
Factor indices and smart beta
Innovative indices
The commercial indices
Indexation and exchange-traded funds
Bespoke “custom-made” indices
Tying it all together
Appendix: The GICS methodology
Bibliography
Disclaimer
INTRODUCTION
“The three-factor model, and the CAPM, which is a one-factor model, have a common factor, the market factor. But the three-factor model has the two additional factors, the size factor and the value factor, hence the three-factor model. As a result, this model allows us to measure the sensitivity of whatever portfolio we’re testing to the size factor and the value factor, in addition to the market factor, which was the single factor in the CAPM model. So, if I have a portfolio that is market-like, I have a beta of one. When all these factors are present, the betas on nearly all diversified equity portfolios become one.”
—Rex Sinquefield, index-fund pioneer
In this chapter, we shift our focus to the concept commonly referred to as “smart beta”, acknowledging its somewhat inappropriate nomenclature. As established earlier, an index serves as a surrogate for the market, but the market undergoes daily fluctuations influenced by various macroeconomic factors. Index constructors continually grapple with these changes, necessitating the consideration and capture of such factors.
Factor analysis emerges as a valuable tool in the index constructor’s toolkit. A factor, in this
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