Efficient exposure to low volatility, momentum, quality and value

INDEX INSIGHTS
Efficient exposure to low volatility,
momentum, quality and value
By: Rolf Agather, Managing Director, Research & Innovation
JUNE 2014
Key points:

The Russell High Efficiency Factor Index (HEFI) series provides exposure to four
commonly understood factors that drive equity returns: Low Volatility, Momentum, Quality
and Value.

The Russell HEFI methodology produces strong factor capture and low correlations among
factors, while also reducing concentration risk and turnover.

The Russell HEFI methodology uses a consistent framework for achieving factor exposure
and managing active risks.
Introduction
For more than 30 years, Russell Investments has been a leader in the design and development
of equity indexes. From the creation of its U.S. index series in 1984 to more recent innovations
in global equities and “smart beta” indexes, Russell has consistently produced indexes that
serve the needs of investors.
The Russell High Efficiency Factor Index (HEFI) series continues this tradition of innovation by
providing investors with new tools that enable them to understand, analyze and ultimately
invest in more precise factor exposures. The Russell HEFI series provides insights into four
commonly understood factors that drive equity returns: Low Volatility, Momentum, Quality and
Value. In addition to Russell’s own proprietary research, extensive literature within academic
and investment practitioner communities describes these factors.
What makes the Russell series unique is its thematically consistent design and construction.
While unique data elements are used to define the factors themselves, the Russell style
algorithm is used consistently to determine a company’s weight in each index. In addition to
providing robust factor capture, the Russell HEFI series is designed to reduce elements of
active risk such as concentration risk and turnover.
Russell Investments // Summary: Russell High Efficiency Factor Indexes (HEFI)
For more information
on the Russell High
Efficiency Factor
Indexes see
russell.com/indexes
for a paper titled
“Russell High
Efficiency™ Factor
Index Series:
Providing investors
with efficient
exposure to return
drivers”
Methodology Overview
1
The Russell HEFI series is designed to produce strong factor exposure by weighting the
individual stocks by factor signal instead of by market capitalization. This means that stocks are
weighted on the basis of how strongly they exhibit a particular factor behavior. For example,
stocks with high momentum characteristics would be weighted higher in the Russell HEFI
Momentum index. The data elements used to determine a stock’s factor behavior are listed in
Table 1.
Table 1: The Russell HEFI series: factor definitions
Factors
Styles
Russell High Efficiency™ Quality Index (HEQI)
Return on assets
Debt to equity
5-year earnings variability
Russell High Efficiency Low Volatility Index (HELVI)
52-week total return volatility
60-month total return volatility
Russell High Efficiency Momentum Index (HEMI)
11-month total return lagged 1 month
Russell High Efficiency Value Index (HEVI)
Book/price ratio
Earnings/price ratio
The primary purpose of the Russell HEFI series is to provide strong factor capture. Doing this
effectively requires a deviation from the traditional index method of capitalization-weighting
stocks and, instead, assigning each company an “active weight” according to the relative
strength of its factor signal. Ideally, stocks with higher/lower factor signals will have
higher/lower weights in the index. At the extremes, stocks with the lowest factor signals will be
excluded from the factor index (no short positions are allowed), and stocks with the highest
factor signals will have upper limits on their weights so as not to allow concentration on any
single stock, and also to reflect the fact that there may be limits to how much information about
a stocks factor signal is indicated by stocks with extreme values.
In addition to strong factor capture, the Russell HEFI series is designed to be “active-riskaware.” Any strategy that weights stocks in a manner other than cap weighting introduces
active risk relative to the benchmark. While it is necessary to have some amount of active risk
in order to produce a desired factor exposure within the index, it is possible to minimize the
amount of active risk taken. In the Russell HEFI methodology, Russell uses its nonlinear
probability (NLP) algorithm with explicit parameters for controlling the over- and underweighting
of stocks in the index. Because the total weight of underweight stocks must by index definition
equal the total weight of overweight stocks, we have a wide range of choices to make with
regard to the magnitude of a stock’s active weight relative to the parent index. We could
choose to have a greater number of stocks with relatively small over-/underweights, or a
smaller number of stocks with relatively large over/underweights.
Based on Russell’s empirical research and experience in developing investable indexes, the
design principle applied to the HEFI series is to take a large number of small bets (active
positions), rather than a small number of large bets, to produce the desired factor exposure.
1
For more information on the construction and methodology:
http://www.russell.com/indexes/americas/indexes/construction-methodology.page?
Russell Investments // Summary: Russell High Efficiency Factor Indexes (HEFI)
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This enables the HEFI series to achieve strong factor capture while minimizing the amount of
active risk being taken.
Key features/benefits
By its use of a consistent methodology to determine a stock’s factor signal and resulting weight
in each factor index, the Russell HEFI series provides a number of key benefits, which we
discuss below.
Consistent, strong factor capture
As a test for factor exposure consistency, we performed both holdings- and returns-based
exposure analyses of the Russell U.S. and Global HEFI returns using the Axioma MediumHorizon, Fundamental Factor Risk Model. Over the 15-year period January 1999 through
December 2013, the returns analysis showed a strong and significant relationship between
each of the HEFI indexes and its Axioma factor proxy. A holdings-based analysis over the
same period also showed that each HEFI index maintained consistent exposure to its Axioma
factor proxy.
Lower concentration risk
To confirm that the indexes are active-risk-aware, we analyzed a variety of measures, including
sector weights, tracking error and active share relative to the cap weighted parent index. We
also analyzed concentration measures such as the maximum active weight, sum of the top 10
weights and sum of the top 10 active weights. For the U.S. HEFI series at year-end 2013,
tracking error relative to the Russell 1000® ranged between 2.7% and 7.3%, and active share
ranged between 33.1% and 45.3%. These levels indicate that while active bets are being taken
against the parent benchmark, the overall magnitude of each of these bets is relatively low and
diversified across multiple constituents, rather than being concentrated in a few constituents,
when compared to traditional active strategies.
Lower turnover
Turnover can be a material cost to investors if it is not adequately managed, and the HEFI
series employs a number of techniques to keep turnover at reasonable levels. First,
rebalancing frequency has been set to semiannually, which Russell’s research has shown to
be an optimal balance between investors’ desire to capture factor exposures and the need to
keep turnover – and, ultimately, trading costs – to a minimum. Second, Russell uses a unique
banding approach that keeps positions from being increased or decreased when their target
weights do not significantly differ from their existing weights in the factor index. These
techniques have been shown to reduce annual turnover by 20%, on average, without a
material impact on the return behavior of the HEFI series.
Lower correlations among factors
In addition to the benefit of being able to use individual HEFI indexes as means of achieving
specific exposures, many investors will also want to combine factors in order to realize the
diversification benefit arising from the fact that the individual factor series are not highly
correlated, as shown in Table 2. Because the HEFI series uses a consistent construction
methodology, the exposures and average active weights are consistent across the indexes; so
for investors combining the indexes, it is much easier to control overall exposure and active
positions.
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Table 2: Correlation of monthly excess returns: Russell U.S. HEFI indexes
(July 1996 through December 2013)
R1000 HEMI
R1000 HEQI
R1000 HEVI
R1000 HELVI
R1000 HEMI
1.00
0.47
-0.35
-0.26
R1000 HEQI
0.47
1.00
-0.31
-0.12
R1000 HEVI
-0.35
-0.31
1.00
0.56
R1000 HELVI
-0.26
-0.12
0.56
1.00
Conclusion
The Russell HEFI series provides a compelling and powerful new set of tools for investors. As
an investment strategy, the HEFI factors enable investors to obtain precise exposure to a set of
factors or to combine factors to achieve diversification benefits beyond broad market investing.
The consistent approach used in the construction of the Russell HEFI series allows them to be
used in a broad range of strategic or dynamic multi-factor strategies. What was once available
only to the largest, most sophisticated organizations is now available to a broader range of
investors.
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About Russell Indexes
Russell’s indexes business, which began in 1984, accurately measures U.S. market segments
and tracks investment manager behavior for Russell’s investment management and consulting
businesses. Today, our series of U.S. and global equity indexes reflects distinct investment
universes – asset class, geographic region, capitalization and style – with no gaps or overlaps.
Russell Indexes offers more than three dozen product families and calculates more than
700,000 benchmarks daily, covering 98% of the investable market globally, 80 countries and
more than 10,000 securities. Approximately $5.2 trillion in assets are benchmarked to the
Russell Indexes.
For more information about Russell Indexes, call us or visit www.russell.com/indexes.
Americas: +1-877-503-6437; APAC: +65-6880-5003; EMEA: +44-0-20-7024-6600
Disclosures
Russell Investments is a Washington, USA Corporation which operates through subsidiaries worldwide
and is a subsidiary of The Northwestern Mutual Life Insurance Company.
Russell Investments is the owner of the trademarks, service marks and copyrights related to its
respective indexes.
Westpeak Global Advisors, LLC and Goldman Sachs Asset Management, L.P. are developers of technologies
used in the Russell HEFI Indexes. Russell Indexes has independently developed intellectual property that is
used to construct and maintain the Russell HEFI Indexes.
Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a
guarantee of future performance and are not indicative of any specific investment.
This material is proprietary and may not be reproduced, transferred or distributed in any form without prior
written permission from Russell Investments. It is delivered on an “as is” basis without warranty.
This is not an offer, solicitation or recommendation to purchase any security or the services of any
organization.
Copyright © Russell Investments 2014. All rights reserved. First use: June 2014.
CORP-9577-06-2016
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