Investors should be wary of factor-based indices using “simplistic or naïve metrics”, according to a report from Mercer.

The consultancy giant warned in a white paper on factor investing that index approaches, including exchange-traded funds (ETFs), should be treated with caution despite their rapid growth in popularity in recent years.

“Factor indices can be dangerous,” the consultancy wrote. “They tend to be naïve in their approach and static in their design.” 

Several index providers, including FTSE Russell, MSCI and Standard & Poor’s, have launched indices based on factors such as low volatility, momentum and value.

However, Mercer said that such indices “may lead to an inability to address concentrations of risk, valuation bubbles or crowding”.

In addition, the consultancy warned that indices with publicly available rebalancing rules could be “gamed” by other market participants, and the lack of a proprietary process could lead to the factors being eroded over time.

However, Mercer was broadly positive on factor investing strategies – also known as smart beta – particularly “active multi-factor” approaches.

“Investors making use of factor indices may wish to compare such approaches against active multi-factor strategies,” the report said. “For a relatively small increase in fee level, active multi-factor approaches offer superior risk management and portfolio evolution over time.”

Factor investing in general should be considered an active investing approach, Mercer added – even when used through an index-based approach such as an ETF. This was because every strategy made significant deviations from market cap indexes.

The company also urged investors in “traditional” quantitative strategies to compare these investments to multi-factor products as they could potentially access similar risk exposures at a lower fee.

IPE’s Special Report on factor investing, published in May, is available here. This month’s ETFs Guide is available here.