Scientific Beta

The latest issue of the Pensions & Investments/EDHEC-Risk Institute Research for Institutional Money Management supplement looks at the following topics: Combining Factor Tilts and Diversification Strategies: Towards Smart Factor Indexes; The Performance of Smart Factor Indexes in Developed Economies; and Multi Smart-Beta Allocation: Performance and Implementation Benefits.

Our first article is dedicated to the subject of "Combining Factor Tilts and Diversification Strategies: Towards Smart Factor Indexes". All smart-beta equity strategies are exposed to systematic risk factors and strategy-specific risks. Systematic risks refer to the exposure to risk factors that can be rewarded or not. They arise from the characteristics of the underlying stock universe and also from the portfolio construction. The non-rewarded or specific risk constitutes all the risks that do not have a premium in the long run, and are therefore not ultimately desired by the investor. The Smart Beta 2.0 framework allows for efficient management of exposures to rewarded risks while avoiding unrewarded (specific) risks. The smart factor indexes that result from this framework show pronounced improvements in risk-adjusted performance compared to that of cap-weighted factor-tilted indexes.

In a second article entitled, "The Performance of Smart Factor Indexes in Developed Economies", we analyse the performance of smart factor equity indexes in developed economies, at a local level, and in the global developed stock universe. Smart factor indexes show attractive performance on both an absolute and risk-adjusted basis in different developed markets. For each risk factor, the smart factor indexes outperform the tilted cap-weighted indexes in both relative returns and Sharpe ratio. Moreover, owing to international diversification, we also obtain low levels of tracking error, leading to interesting information ratios. The 5-year outperformance probability is extremely high (95%-100%), meaning the outperformance is both high and robust across these four factors.

Lastly, in an article entitled "Multi Smart-Beta Allocation: Performance and Implementation Benefits", we look at the performance and implementation benefits of multi-smart beta allocation, a new source of value added in investment management. Compared to the average stand-alone investment in a smart factor index, multi-beta indexes almost always result in higher average returns net of costs owing to the turnover reduction through natural crossing effects among the component smart factor indexes.