Question

Explain the difference between directional policy matrices and multiple factor indices.

Answer 1

Directional PolicyMatrix (DPM) analysis is aimed at determining the appropriate strategic planning goals and the right strategies to achieve those goals across the portfolio of products, strategic business units (SBUs) and markets. In broad terms, the DPM is a framework and process to review the performance and relative potential of each product/SBU/market and to decide which products/SBUs/markets to-

- Build/develop further/increase market share of

- Maintain/resource to keep the status quo or current market share

- Harvest/sell off or withdraw from having squeezed the last potential sales

- Divest/drop or exit immediately.

For best results, the DPM analysis should involve marketing, sales and operations managers in both plenary and group sessions. It is very important that all can contribute and thereby all can own the outcomes. In process terms, the DPM analysis involves nine steps.

1. DETERMINE MARKETS- The first step is to define and agree the markets/SBUs/product groups or segments that the business sees itself competing in. This should be heavily informed by the external perception – the customers. For example, in the case of the railway industry in the US market, customers re-defined the market as “transport” when the option of car and air travel became available. Once the markets have been defined, size them in current sales terms and at your future strategic goal date.

2. DECIDE MARKET ATTRACTIVENESS FACTORS AND 3. WEIGHT/RANK
For each product/SBU/market segment, establish and agree the four key factors that define “attractiveness” relative to the overall market. You then weight their importance and score where these factors are likely to evolve over the planning period. This yields a ranking score, which plots that market on the “attractiveness” axis of the DPM Grid. Figure 5.1 is an example of market attractiveness ranking for a financial services product.

4. DEFINE THE CRITICAL SUCCESS FACTORS FOR MARKET POSITION AND 5. WEIGHT SCORE AND RANK- Decide what the critical success factors are in establishing a strong market position. Again, weight each factor and score it in relation to its evolution over the planning period. This then yields a market position ranking on the horizontal DPM Chart Axis (below). Figure 5.2 shows the market position for the same financial product above.

6. PLOT THE MARKET ATTRACTIVENESS/MARKET POSITIONS ON THE DPM CHART, 7. AGREE PLANNING GOALS, 8. SET OBJECTIVES. 9. DESIGN STRATEGIES.

Once each product/SBU/market segment has been scored and ranked, the results are plotted on the DPM chart. According to where each product/SBU/market segment lands in the nine sectors of the chart, there are planning goals recommended for future evolution. Guided by these planning goals, the management teams then set objectives and define strategies to realise those objectives.

Multiple Factor Indices- It wasn’t too long ago that the concept of factors in investing was the exclusive province of professors of finance and a few active “quant” managers. Mainstream portfolio construction was focused primarily on asset allocation. Within equities, that meant achieving the right balance in allocation to various segments such as large cap and small cap, country and sector, and perhaps value and growth styles.

Today, factor allocation has entered the mainstream as a complementary approach to portfolio construction, alongside traditional asset allocation. An important driver of this development has been the creation of a new array of indexes that sharply focus on one factor at a time. This has opened up new possibilities for asset owners and advisors, including investing in index-replicating financial products, both to seek a desired factor exposure at low cost and to benchmark active managers to assess their value added.

Market participants who do not employ a factor-timing or factor-rotation strategy are increasingly looking at strategic combinations of factors to gain potential improvements in risk-adjusted outcomes as compared to single-factor outcomes.

A multi-factor composite index- The most common and simplest way to construct a multi-factor index is to take a weighted average of two or more single factor indexes, say 50% value and 50% quality. The advantage of this approach is its top-down simplicity. In principle, this is no different than replicating single factor indexes in the chosen weights. An advantage in having both factors together in one index is that the index provider maintains the fixed weights, relieving the market participant of having to adjust index-replicating products. The main concern is that the averaging process could dilute the factor exposures. We will show this is a valid concern.

Benefits of Multiple factor Indices-

- By constructing the portfolio at the securites level, it provides efficient and controlled exposure to target factors and minimizes unintended exposure dilution in a single portfolio.

- Provides investers with a strategy that aims to help them achieve active returns without increasing the risks, compared to the underlying market risks.

- Mitigates the cyclicality of individual factors, eliminating the need for factor timing, reducing tracking errors compared to the underlying market.

- Significantly diversifies the risk charecteristics of the corresponding single factor indexes that have historically generated premia over the market over long time periods.