Scientific Beta

In the November 2014 issue of the P&I EDHEC-Risk Institute Research for Institutional Money Management supplement, several articles are dedicated to the subject of smart beta, examining smart factor indices, the investability and robustness of smart-beta strategies, and comparing equity factor index offerings from major index providers.

Current smart-beta investment approaches provide only a partial answer to the shortcomings of capitalization-weighted indexes. We introduce smart factor investing. We address the two main shortcomings of cap-weighted indexes: undesirable factor exposures and heavy concentration, constructing factor indexes that explicitly seek exposures to rewarded risk factors while diversifying away unrewarded risks. The results suggest that smart factor indexes lead to considerable improvements in risk-adjusted performance. These smart factor indexes are not the end point, but the starting point, for investing in equities in a smart way. Constructing smart-beta allocation solutions while respecting risk objectives can be expressed in absolute or relative terms.

Risk allocation with smart factor indexes is examined in a case study with factor exposure constraints. It is possible to perform risk parity in the long-only world, to have an exposure that is equal in terms of risk factors rewarded over the long term without necessarily having pure or orthogonal factors that are impossible to obtain in the long-only space. This is important when, under the pretext of purity, investors choose excessively concentrated factor indexes that contribute neither purity nor diversification and therefore have a fairly low risk-adjusted return. Our argument is that by using well diversified investible proxies for each factor (the Scientific Beta smart factor indexes), it is possible to implement high-performance allocation among these indexes, while respecting factor-risk parity constraints. The first two articles provide solutions that have been the subject of extensive research conducted by EDHEC-Risk Institute with the support of Amundi ETF & Indexing.

A question that all investors raise with an innovative solution is its investibility. The object of the fourth article is to describe how to ensure the investibility of smart-beta indexes by managing turnover control and capacity constraints. Investors in smart-beta indexes require access to solutions where implementation costs and liquidity risks are thoroughly considered. The smart-beta index turnover and capacity constraints need to be carefully handled through the construction of the index.

The results presented in this supplement are sufficiently impressive for investors to question their robustness. We examine their robustness in two ways. Relative robustness, which corresponds to the capacity for a smart-beta index exposed to clearly identified systematic risk factors to be always exposed to the same outperformance compared to the return given by the market for that, or those, factor(s). Relative robustness can be improved by reducing all sources of unrewarded risks with the use of a consistent framework, robust parameter estimation techniques, weight constraints, and diversification of strategy-specific risk. Second, absolute robustness, raises the question of the capacity of the smart-beta index to outperform the market whatever the time period or, more specifically, whatever the market regimes or returns associated with a systematic risk factor. Robustness can be achieved through allocating across several rewarded factors. Our results show that single factor indexes have a high degree of relative robustness, but they are not robust in absolute terms. Multi-beta allocations, on the other hand, are robust in absolute terms.

Finally, we provide a brief overview of equity factor index offerings from major index providers. Factor indexes provide explicit exposure to a common risk factor in order to achieve its long-term risk premia.