Scientific Beta

Smart beta equity indices are growing in popularity as alternatives to market-cap weighted indices. However, a major question mark hanging over their investability is the cost to investors of trading these index constituents in the same proportions as the underlying strategy. The objective of this paper is to describe how Scientific Beta ensures the investability of its indices using turnover controls and liquidity constraints. We will also present the resulting turnover and liquidity measures of these very indices.

Smart beta equity indices are growing in popularity as alternatives to market-cap weighted indices. However, a major question mark hanging over their investability is the cost to investors of trading these index constituents in the same proportions as the underlying strategy. The objective of this paper is to describe how Scientific Beta ensures the investability of its indices using turnover controls and liquidity constraints. We will also present the resulting turnover and liquidity measures of these very indices.

Within the Scientific Beta index construction process, adjustments are performed to ensure their investability, either by reducing and controlling turnover-related costs, or by improving their liquidity profile in a systematic, robust and transparent manner. We use a conditional rebalancing methodology, which works on the principle of avoiding trading until a sufficient amount of new information has arrived. This approach reduces the turnover of various strategies with only a minimal reduction in performance. We use a liquidity filter to ensure sufficient liquidity of the broad stock universe. Finally, additional liquidity constraints restrict deviations from the cap-weighted reference index, managed in terms of individual component market capitalisation, and prevent large weights from being given to the least-liquid stocks.

In this paper, we describe the different aspects of the Scientific Beta approach to implementation management and cost control, and explain how our adjustments impact key implementation metrics such as the turnover, capacity and liquidity of various strategies. We also use recent advances in market microstructure research to estimate the transaction costs of our smart beta indices. We discuss in detail the turnover and liquidity profiles of single- and multi-factor indices.