Scientific Beta

The latest edition of the EDHEC Research Insights supplement to IPE is a Scientific Beta special issue, containing articles on the management of market risk in the design of factor indices, presenting an investable long/short market-neutral strategy, a leveraged beta one solution, a diversified max factor exposure solution, and narrow high factor intensity smart factor indices, together with a discussion on the merits of a "top-down" approach to multi-factor investing.

The latest edition of the EDHEC Research Insights supplement to IPE is a Scientific Beta special issue.

We first focus on the management of market risk in the design of factor indices, a topic that is generally neglected in current index offerings. We propose a robust method to measure a factor strategy’s market beta that relies on up-to-date information on the index composition, the use of shrinkage techniques and model averaging to overcome the problem of changing index composition and strong variability in market betas.

We then introduce an investable long/short market-neutral multi-factor strategy. Scientific Beta’s methodology focuses on risk management and factor diversification to construct a portfolio with minimum volatility. The diversification of idiosyncratic risk in the long leg components drives risk-adjusted performance and the use of improved beta estimation techniques ensures that the strategy’s market neutrality is strictly respected out-of-sample. We show that a risk minimisation objective is not only superior to spread maximisation in terms of risk-adjusted performance but it also provides room for more leverage and hence higher returns without any additional exposure to market risk.

We look at the first order issue for investors of market risk. Scientific Beta has developed a leveraged beta one solution as a possible way to manage the exposure to the market factor, which plays a dominant role in explaining the return and variability of multi-factor smart beta products. The leveraged beta one solution allows investors to target a market beta of one by leveraging a multi-beta index.

One major investor objective in the multi-smart-factor index arena is to build a strategy with an objective of maximising exposure to long-term rewarded factors without compromising the benefits of diversification. In our following article, we introduce the objectives, methodology and benefits of a diversified max factor exposure solution that meets this goal.

We then recall the merits of ‘top-down’ approaches compared to ‘bottom-up’ approaches on the basis of three popular questions among investors. We look at why it is better to ignore the fine grain differences in factor characteristics among stocks. We then discuss in-sample optimisation and the lack of robustness associated with the high degree of freedom in portfolio construction possible through the ‘bottom-up’ approach. Finally, we provide guidance on the choice of metrics that will help investors to compare multi-factor indices.

Finally, we briefly present the well-thought out construction methodology of narrow high factor intensity smart factor indices and assess their performances as stand-alone indices, showing how these indices can be used in an allocation framework to achieve strong factor tilts and solve other related problems using a simple factor overlay case study.