Contrast factor-tilted index strategies with plain market-cap-weighted indexing
The idea
Market-cap weighting is the default passive approach: it rebalances itself, has low turnover and high capacity, and represents the holdings of the average investor, but it piles weight into the largest and possibly overvalued stocks. Factor-based (smart beta) strategies follow rules-based indexes that tilt towards exposures such as value, size, momentum, quality or low volatility, seeking a return premium or lower risk. They stay transparent and cheaper than active management, yet bring higher turnover, capacity limits, factor crowding and long spells of underperformance against the cap-weighted market. The trap is calling factor strategies purely passive: choosing the factor, its definition and the rebalancing rule are active decisions, so the relevant risk is tracking error against a broad cap-weighted benchmark.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Index-Based Equity Strategies
- Contrast the alternative ways of designing an index-based equity strategy
- Contrast the vehicles through which an investor can gain index-based equity exposure
- Weigh full replication against stratified sampling and optimisation as ways to build an index-tracking equity portfolio
- Explain why an index portfolio can drift from its benchmark and how that tracking error is kept in check
- Identify where the returns and the risks of an index-tracking equity portfolio come from