Scientific Beta

This article, published in the 2018 "Quantitative Strategies: Factor Investing" Special Issue of the Journal of Portfolio Management discusses how the importance of understanding and controlling exposure to the well-known market factor is crucial for smart beta investors.

Smart beta strategies, due to their systematic and transparent nature, allow us to understand and manage their risks. Despite this potential, smart beta research and applications have a long-standing record of insufficient risk transparency. The first applications focused on alternative weighting schemes without necessarily being transparent about the implicit exposures of such weighting schemes to equity factors such as value and momentum (see the criticisms by Amenc, Goltz and Lodh [2012]). Recently, the focus has shifted to factor indexes that explicitly target designated nonmarket equity factors, thus addressing such criticism. Indeed, considering exposure to nonmarket factors has undoubtedly become the main subject of smart beta research and analysis.

Understanding which nonmarket factors are targeted by a strategy is obviously useful, but the advent of smart beta does not mean that we should forget about traditional market beta. Instead, we will argue that market beta is the most important driver of most smart beta strategies. In fact, the market beta of a strategy heavily influences its conditional performance. Ignoring the effects of market exposure may lead to misinterpretation of backtest results, which may have benefited from exposure biases that were aligned with particular market conditions during the backtest period. Moreover, ignoring market exposure may lead to misalignment with the investor's policy benchmark. Market beta biases in the equity portfolio can create deviations from the target equity exposure. Understanding exposure to the well-known market factor is thus crucial for smart beta investors.