Factor indices are a far cry from “passive” investing and may be ill-designed to deliver optimal risk-adjusted returns.

Investors tend to equate factor indexing with “passive” investing—a theoretically straightforward, set-it-and-forget-it exercise in tracking various swaths of the market. The truth, we find, is far from it: Upon closer inspection, we believe navigating the universe of factor indices—now with nearly $2.1 trillion under management—can be a challenging journey with many potential pitfalls.

This paper continues our exploration of the limitations of equity indexation. Earlier installments addressed the opaque and arguably illogical construction methodologies of putatively passive market-capitalization-weighted benchmarks (here), net-zero-focused benchmarks (here), and commodity benchmarks (here)—all of which are now tracked by hordes of index funds.

In this fourth chapter, we demonstrate a) that factor indices are based on many active decisions by index providers, and b) why we think active factor managers have the potential to deliver superior risk-adjusted returns.