Scientific Beta

This special issue of the EDHEC-Risk Institute supplement to AsianInvestor on smart beta begins by looking at the consequences for investors of the development of passive equity investment and “smart beta” indices. It also examines the live performance of the Efficient Maximum Sharpe Ratio (MSR) indices that EDHEC-Risk Institute has been producing with FTSE since 2009 and compares it both to smart beta indices from other providers and EDHEC-Risk Institute's more recent index offerings within the Scientific Beta framework. Additional articles focus on the link between the well-known value factor on the one hand, and the profitability and investment factors on the other hand, the robustness of the first generations of smart beta indices on the basis of live track records, and what investors can learn from academic research on long-term rewarded equity factors.

This smart beta special issue looks first at the consequences for investors of the development of passive equity investment and “smart beta” indices. A key issue with these indices that has not yet been resolved, and is not being attended to properly by regulators, is their level of transparency and the provision of detailed information on the indices to investors. Even though the historical performances of these indices are simulated for the most part, it is not possible to check the accuracy and the quality of these track records because the market does not have sufficiently detailed historical composition and construction methodologies to be able to replicate the performances. EDHEC-Risk Institute has responded to this situation by setting up Scientific Beta, a platform that provides free access to the most detailed information possible on the risks, composition and
methodologies of thousands of smart beta indices that are representative of the rewarded factors documented in the academic literature.

Given this reliance on the simulated historical performance of smart beta indices, we examine the live performance of the Efficient Maximum Sharpe Ratio (MSR) indices that EDHEC-Risk Institute has been producing with FTSE since 2009 and compare it both to smart beta indices from other providers and EDHEC-Risk Institute's more recent index offerings within the Scientific Beta framework, which allow the Efficient MSR weighting scheme to be combined with explicit factor tilts, as well as with additional weighting schemes.

With the emergence of new factor models, discussion among researchers and practitioners has recently turned to the link between the well-known value factor on the one hand, and the profitability and investment factors on the other hand. In particular, a common question raised by investors in practice is whether value is redundant with the profitability or investment factors. Our article examines this question.

The performance of systematic equity investment strategies is typically analysed on backtests that apply the smart beta methodology to historical stock returns. Concerning actual investment decisions, a relevant question therefore is how robust the outperformance is. We examine the robustness of the first generations of smart beta indices on the basis of live track records and observe that differences in live performance are due to the attention given to the design of robust weighting schemes.

We look at what investors can learn from academic research on long-term rewarded equity factors. Index providers put strong emphasis on the academic grounding of their factor indices. It therefore seems useful to analyze what academic research has to say on equity factors to understand what we can learn from such research on designing or evaluating factor indices. A minimum requirement for good practice in factor investing is to avoid creating a mismatch with academic factors.