Passive equity strategies

I know this shouldn’t be a tough concept, but I’m really struggling to understand the difference between passive factor-based strategies and market-cap-weighted indexing (and wasted the entire day on it). Would really appreciate any thoughts on the below questions:

  1. Are these the 2 primary forms of passive indexing (factor-based strategies & market-cap-weighted indexing)? The CFAI refers to these 2 strategies, but what about price-weighted indexing and equal-weighted indexing, for instance?

  2. It seems like market-cap weighted indexing uses a single-factor model with exposure to market risk only (beta) and that factor-based strategies are usually multi-factor models with several risk factors (smart beta). Is this correct?

  3. What’s the difference between factor-based strategies and stratified sampling? My understanding that they both replicate the risk exposures of an index, but a factor-based strategy will alter those investment weights based on risk beliefs. Is that correct?

  4. Why do factor-based portfolios have multiple benchmarks (one that is factor-based and one market-cap-weighted)? I can’t make sense of this

  5. What is the difference between factor-based strategies in the passive equity section vs. the active equity section?

@S2000magician … if you have time to provide insight on any of the these, it would be extremely helpful

Passive factor based strategies are “enhanced index” strategies that are really an active management style but is done so systematically so that the costs of the approach is usually notably lower than traditional active management (but typically higher than passive index strategies).

  1. You’re referring to different ways to construct an index. Passive funds track the performance of an index regardless of how that index is constructed. A passive fund will never (theoretically) outperform the index it aims to track because of fees.
    Factor based / Smart Beta / Enhanced Index strategies (all the same thing) have an outperform target - usually something minor like 50bps but that’s a significant difference in the two approaches which will help differentiate here.

  2. Correct :slight_smile:

  3. Stratified sampling can be used to “refine” the list of investments needed to accurately replicate the characteristics of an index. If the index invests in 5k stocks you could refine this investment universe so that you can closely track the index performance while only being invested in a fraction of the 5k stocks. This is useful if the fund size is relatively small because the cost of full replication is an important factor to consider.
    Factor based strategies aim to outperform the index and so to do that, there is typically over or underweight exposures to factors that are believed to relatively outperform. There are alot of factors that can be used, obvious ones are small cap Vs Large cap, growth Vs value (P/B P/E etc.)

  4. An appropriate benchmark should represent the fund strategy (SAA) or investment universe.

  5. Factor-based will have an outperform objective, passive will have a low tracking error objective.

Hope this helps clarify. Have a look at a passive fund factsheet and an enhanced index fund factsheet if you’re still keen for further clarity, might help.

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This is great. Thanks a lot