Scientific Beta

The August 2015 issue of the P&I EDHEC-Risk Institute Research for Institutional Money Management supplement is entirely dedicated to the subject of smart beta, with articles looking at the consequences for investors of the development of passive equity investment and "smart beta" indexes, examining the live performance and long-term track records of ERI Scientific Beta indexes, analysing whether the well-known value factor is redundant with the profitability or investment factors, discussing robustness issues, asking what investors can learn from academic research on long-term rewarded equity factors, comparing the results of smart factor indexes with several stylized examples of concentrated factor indexes, and finally asking whether factor investing is truly a new welfare-improving investment paradigm or merely another marketing fad.

In this supplement, we look first at the consequences for investors of the development of passive equity investment and “smart beta” indexes. A key issue with these indexes that has not yet been resolved, and is not being attended to properly by regulators, is their level of transparency and the provision of detailed information on the indexes to investors. Even though the historical performances of these indexes are simulated for the most part, it is not possible to check the accuracy and the quality of these track records because the market does not have sufficiently detailed historical compositions and construction methodologies to be able to replicate the performances. EDHEC-Risk Institute has responded to this situation by setting up Scientific Beta, a platform that provides free access to the most detailed information possible on the risks, compositions and methodologies of thousands of smart beta indexes that are representative of the rewarded factors documented in the academic literature.

Given this reliance on the simulated historical performance of smart beta indexes, we examine the live performance of the Efficient Maximum Sharpe Ratio (MSR) indexes that EDHECRisk Institute has been producing with FTSE since 2009 and compare it both to smart beta indexes from other providers and EDHEC-Risk Institute's more recent index offerings within the Scientific Beta framework, which allow the Efficient MSR weighting scheme to be combined with explicit factor tilts, as well as with additional weighting schemes.

With the emergence of new factor models, discussion among researchers and practitioners has recently turned to the link between the well-known value factor on the one hand, and the profitability and investment factors on the other hand. In particular, a common question raised by investors in practice is whether value is redundant with the profitability or investment factors. Our article examines this question.

Performance analysis of systematic equity investment strategies is typically conducted 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 look at this question in terms of relative robustness and absolute robustness. A strategy is assumed to be “relatively robust” if it is able to deliver similar outperformance in similar market conditions. Absolute robustness is the capacity of the strategy to deliver risk-adjusted performance in the future to a degree that is comparable to that of the past owing to a well-understood economic mechanism rather than just by chance. We appraise the robustness of the first generations of smart beta indexes 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 look at what investors can learn from academic research on long-term rewarded equity factors. Index providers put strong emphasis on the academic grounding of their factor indexes. It therefore seems useful to analyze what academic research has to say on equity factors to understand what we can learn from such research on designing or evaluating factor indexes. A minimum requirement for good practice in factor investing is to avoid creating a mismatch with academic factors. This can be achieved easily by referring to indicators for which academic research has provided thorough tests and economic explanations, and by refraining from proprietary “tweaks.”

The objective of the following article is to compare the results of smart factor indexes with several stylized examples of concentrated factor indexes. Our conclusion is that increasing concentration leads to high turnover levels and real investibility hurdles which are not compensated by any performance advantages.

Our final article asks whether factor investing, which recommends that allocation decisions be expressed in terms of risk factors, as opposed to standard asset class decompositions, is truly a new welfare-improving investment paradigm or merely another marketing fad. The first challenge for investors who decide to express their decisions in terms of factor exposures is the identification of meaningful factors. Recent research that we have conducted as part of the Lyxor “Risk Allocation Solutions” research chair at EDHEC-Risk Institute reviews the academic literature on asset pricing and makes a list of conditions that such factors should satisfy. We then survey the empirical literature in order to identify the most consensual factors in three major asset classes, namely stocks, bonds and commodities. Empirical tests show that investible proxies for factors add value in single-class or multi-class portfolios when they are used as complements or substitutes for broad asset class indexes. Moreover, in the equity class, a portfolio of factor indexes dominates a portfolio of sector indexes.