Scientific Beta

This Scientific Beta special issue of the Research Insights supplement in partnership with Investment & Pensions Europe (IPE) examines a number of topics on the theme of smart beta. Among the key research results presented in this issue are the merits of diversified as opposed to concentrated factor indices, smart beta solutions through allocation between existing smart factor indices, and the robustness of the first generations of smart beta indices on the basis of live track records.

This Scientific Beta special issue of the Research Insights supplement to IPE begins by looking at ‘quality’ investing and more specifically the role of two separate equity risk factors related to balance sheet characteristics: low investment and high profitability. These factors rely on straightforward, parsimonious indicators, and can be expected to provide more robust performance benefits than ad-hoc stock picking indicators of quality used in the industry. Further value can be added by allocating across these two factors to exploit the low correlation across factor returns. Such combinations of the smart factor indices for high profitability and low investment have led to improved performance compared to various commercial indices which are based on ad-hoc definitions of quality.

One of the questions frequently asked about the quality factor, or factors, is the nature of its relationship to the value factor, and whether in fact quality might be redundant if one is already investing in value. We examine this question in detail and conclude that the profitability and investment factors are neither subsumed by other factors such as value and momentum, nor do they make these other factors redundant.

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 compare the results of smart factor indices with several stylised examples of concentrated factor indices. We conclude that increasing concentration leads to high turnover levels and real investability hurdles which are not compensated by any performance advantages. The solution, as the title of the article suggests, is to go back to basics and focus on diversification when constructing factor indices.

We look at what academic research can teach investors about equity factors that are rewarded over the long term. Index providers emphasise the academic foundations of their factor indices, so it is useful to analyse what academic research has to say on equity factors. A minimum requirement for good practice in factor investing is to create a good match with academic factors. This can be achieved by referring to indicators for which academic research has provided thorough tests and economic explanations.

In addition to the question of selecting a suitable index as a stand-alone investment, the question of combining different smart beta strategies naturally arises in the context of an extensive range of smart beta offerings. Our article addresses the issue of combining several smart beta strategies, and clarifies the conceptual underpinnings and relevant questions arising when considering smart beta index combinations.

We show that, on the basis of existing smart factor indices, allocation between these indices can allow an investor who wishes to implement a defensive strategy to avoid concentration in a single factor and above all to benefit from the particular properties of volatility and its dissymmetric nature with respect to market conditions, and thereby adjust the portfolio’s defensive bias to market conditions.

In our final article, we find that value, in terms of risk-adjusted relative performance, can be added through allocation across smart factor indices, for investors with a tracking error budget. The favourable factor tilts generate outperformance and two-fold diversification, one across factors and another across weighting schemes, reducing tracking error. Implementation of an allocation that guarantees a level of market beta equivalent to that of a cap-weighted index allows the benefits of this relative risk diversification to be optimised.