Scientific Beta

This special issue of the EDHEC-Risk Institute supplement to AsianInvestor on smart beta begins by introducing a new approach to equity investing termed ‘smart factor investing.’ It then turns to risk allocation with smart factor indices, examining a case study with factor exposure constraints. Further articles look at solutions for allocating to smart beta, describe how to ensure that smart beta indices are investable by managing turnover and capacity constraints, and examine their robustness in relative and absolute terms. Finally, the supplement provides a brief overview of equity factor index offerings from major index providers. 

This smart beta special issue begins by introducing a new approach to equity investing termed ‘smart factor investing.’ The results suggest that smart factor indices lead to considerable improvements in risk-adjusted performance. These smart factor indices are not the end point for investing in equities in a smart way, but instead the starting point, ingredients to construct smart beta allocation solutions while respecting risk objectives that can be expressed in absolute or relative terms. This first article provides a panorama of solutions that have been the subject of a considerable research effort conducted by EDHEC-Risk Institute with the support of Amundi ETF & Indexing.

Turning to risk allocation with smart factor indices, we examine a case study with factor exposure constraints in a second article. We show that it is possible to perform risk parity in the long-only world, i.e. to have an exposure that is equal in terms of risk factors rewarded over the long term without necessarily having pure or orthogonal factors that are impossible to obtain in the long-only space.

As part of our solutions for allocating to smart beta, we find that value can be added through relative Equal Risk Contribution and relative Global Minimum Variance at the allocation stage, for investors with a tracking error budget. As a result, extremely substantial levels of risk-adjusted outperformance (information ratios) can be achieved even in the absence of views on factor returns.

The question that all investors raise for an innovative solution is its investability. The objective of the fourth article is to describe how to ensure that smart beta indices are investable by managing turnover control and capacity constraints.

The results we present are sufficiently impressive for investors to raise the question of their robustness. Our results show that single factor indices have a high degree of relative robustness, but they are not robust in absolute terms. Multi-beta allocations, on the other hand, are highly robust in absolute terms.

To conclude this special issue on smart beta, we provide a brief overview of equity factor index offerings from major index providers. Factor indices aim to provide explicit exposure to a common risk factor to harvest its long-term risk premia.