Smart Beta and Interest Rate Rises:
What Would Have Happened Last Time?

Tom Goodwin, PhD
Senior Research Director
FTSE Russell

With the recent rise of smart beta against the backdrop of a looming interest rate rise expected from the Federal Reserve Bank (the “Fed”), many investors are wondering how these indexes might respond to a rate increase. Factor indexes—designed to capture the systematic return to a specific set of company characteristics—are of particular interest, given that few of them were around when the Fed raised rates in the past. In this blog post, we aimto shed somelight on the consequences for smart beta by looking at simulated returns for six FTSE Russellfactor indexes during the last sustained period of rising rates.

We will focus on the 2004 – 2007 period, when the Fed began a restrictive stance to monetary policy that led to a steady rise of the Fed Funds Rate from 1%in June 2004 to a peak of 5.26% in July 2007.


Sources: Federal Reserve Bank and FTSE Russell as at 30 July 2007. Past performance is no guarantee of future results. Returns of the factor indexes are simulated. Please see the final page for important legal disclosures.

The figure above plots six simulated FTSE Russell factor indexes over this time period. The factors are momentum, illiquidity, quality, size, value and volatility.[1] The returns are expressed in the form of the growth of $1 over the FTSE USA index broad benchmark. This is equivalent to cumulative excess returns over the FTSE USA index broad benchmark. Excess returns were chosen as they effectively back out common market movements that might otherwise obscure differences between the factor indexes.

The figure reveals a distinct bifurcation of the six indexes into two groups of three. One group consists of the value, illiquidity and size factor indexes which would have steadily outperformed the FTSE USA index broad benchmark during the period of monetary tightening. The second group consists of the quality, momentum and volatility indexes which would have been essentially flat against the broad benchmark during this period.

Table 1 shows what the compound excess returns to the six factor indexes would have been over the period of monetary tightening. It confirms what we see in the figure, namely the substantial outperformance of value, illiquidity and size versus the broad benchmark-like performance of momentum, quality and volatility during this period.

Table 1 Annualized Excess Return of Factor Indexes Over the FTSE USA Index
June 2004 – July 2007
Momentum / Illiquidity / Quality / Size / Value / Volatility
Factor Index / 0.25% / 2.91% / 0.42% / 3.30% / 3.83% / -0.62%

Source: FTSE Russell as at [insert date]. Past performance is no guarantee of future results. Returns reflect simulated performance. Please see the final page for important legal disclosures.

It’s important to note these are simulated returns and correlation is not causation, so one should exercise caution in interpreting these results. Nonetheless, as factor indexes have grown in popularity we hope we have shared some interestingperspectiveon this important issue.

[1] Reference here to relevant FTSE documentation explaining these indexes.