Scientific Beta

The latest edition of the EDHEC Research Insights supplement to IPE contains articles on misconceptions and mis-selling in smart beta, assessing the investability of smart beta indices and the merits of "top-down" and "bottom-up" approaches to multi-factor index construction.

The latest edition of the EDHEC Research Insights supplement to IPE contains several articles on smart beta.

Even though gaining explicit exposure to priced risk factors in the equity space is expected to provide good long-term risk-adjusted performance, investing in these factors also exposes the investor to a number of hidden or implicit risks that could be important drivers of short-term performance. In our article, we document and gain a better understanding of these hidden risks.

We assess the investability of smart beta equity strategies, as they naturally incur additional implementation hurdles compared to cap-weighted indices. While there are different dimensions related to investability, such as liquidity, capacity and transaction costs, it is possible to provide transparency on these dimensions with a range of metrics developed in market microstructure research. Our article introduces a suite of analytics to enable investors to assess the investability of smart beta indices.

Multi-factor index providers have been debating the respective merits of the ‘top-down’ and ‘bottom-up’ approaches to multi-factor equity portfolio construction. We review general insights from the literature on return estimation and factor models that are relevant for multi-factor portfolio construction and discuss recent literature that specifically addresses issues with bottom-up portfolio approaches.

An understanding of the design choices underlying multi-factor products is crucial if investors are to avoid outcomes that may ultimately disappoint them. Using evidence and beliefs, authors from Legal & General Investment Management LGIM) outline a ‘blank-sheet-of-paper’ approach to designing a particular strategy that places a heavy emphasis on diversification at the factor, region, sector and stock level. This leads to considered objectives for portfolio return, risk and diversification that can be clearly messaged to investors.