Insights | Understanding risk-based index construction

Risk-based indexes apply alternative weighting schemes to achieve improved levels of index-level diversification or risk reduction compared to traditional market capitalization weighted indexes. Risk-based indexes typically target reductions in constituent concentration, risk concentration, index-level volatility, or a combination of these features.

An earlier FTSE Russell Insights, titled “Targeting risk with smart beta indexes,” the first in a series of three, provided an introduction to risk-based indexes and their objectives. In this second article we dig further into the construction methods of risk-based indexes and compare approaches to achieving volatility reduction and/or improved diversification. We explore the implicit factor exposures of risk- based indexes and contrast this with the explicit factor exposure objectives of factor indexes. Finally, we note the importance of appropriate constraints in the construction of optimized indexes to achieve a balance between an index’s objective and usability. In the third Insights in this series we focus on a popular type of risk-based index, minimum variance.

Investors continue to focus on risk reduction Results from the FTSE Russell Smart Beta Survey 2016 (see the following chart) show that risk reduction and improved diversification are two of the primary investment objectives cited by investors evaluating smart beta.

what investment objectives initiated your evaluation of smart beta strategies

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