Scientific Beta

This "Scientific Beta" special issue of the EDHEC Research Insights supplement to AsianInvestor contains articles examining the importance of making sound design choices and applying explicit risk control options, looking at how investors can control implicit sector biases in factor investing, analysing the links between economic states and factor premia, revealing why the most discerning investors should cast a critical eye over prevalent factor box initiatives, and explaining why the measurement of factor exposures should stay grounded in academic research which supports the use of beta-based models.

This "Scientific Beta" special issue of the EDHEC Research Insights supplement to AsianInvestor is dedicated to the theme of smart beta.

We first show that achieving robust exposure to long-term rewarded factors, good diversification of unrewarded risks, and high levels of investability are key requirements for adding value with factor indices. It is clear that this added value is expressed over the long term, but that risk control options can increase the short-term consistency of the outperformance that investors expect.

In this short-term risk-control context, we review the sector-risk-control option offered to investors by Scientific Beta that has been available on its platform since its launch in 2013. We conclude that the choice of using the sector-risk-control option is a trade-off between investors' aversion to short-term risks generated by sector risk and their willingness to harvest factor risk premia in the most efficient way, to achieve the highest risk-adjusted performance over the long run.

On the subject of allocation between factors, ERI Scientific Beta has undertaken extensive research to go beyond the usual approaches based on factor deconcentration or factor balance. In particular, we focus our research on the link between economic states and factor risk premia. We review some of the existing studies in this area from practitioners and then discuss conceptual considerations regarding the selection of relevant variables and propose a methodology for classifying macroeconomic regimes. We analyse the conditionality of factor premia to the macro regimes and give illustrative examples for implications for factor investors.

Finally, since allocating to factors implies that one knows how to identify them and how to measure a portfolio's exposures to them, we examine factor definitions used in analytic tools offered to investors and contrast them with the standard academic factors. We also outline why the methodologies used in popular tools pose a high risk of ending up with irrelevant factors. Most popular factor analysis tools used by investors deviate from the models used in research because they choose to use factor scores instead of betas. Although scores are easy to compute and present a point-in-time snapshot of portfolio characteristics, factor scores have serious shortcomings when it comes to factor exposure measurement. The consequence of this misalignment is that investors may end up with returns that fall short of their expectations.