Scientific Beta

The November 2015 issue of the P&I EDHEC-Risk Institute Research for Institutional Money Management supplement contains several articles on the subject of smart beta equity investing, addressing how to combine several smart beta strategies and clarifying the conceptual underpinnings and relevant questions arising when considering smart beta index combinations, looking at absolute and relative risk allocation with smart factor indexes, and examining the limitations of factor investing through an analysis of the impact of the Volkswagen scandal on concentrated versus diversified factor indexes.

Several articles in this supplement examine the area of smart beta equity investing. We address the issue of combining several smart beta strategies, and clarify the conceptual underpinnings and relevant questions arising when considering smart beta index combinations.

We show that on the basis of existing smart factor indexes, allocation between these indexes 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.

We find that value, in terms of risk-adjusted relative performance, can be added through allocation across smart factor indexes, for investors with a tracking error budget. The favorable 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 optimized.

We show that factor concentration has led many factor indexes to hold Volkswagen AG, and more globally automobile stocks, in large quantities, and ultimately to incur losses in the month of September 2015. Conversely, Scientific Beta’s multi-smart-factor indexes, through their construction philosophy, which distinguishes the choice of factor exposures from the implementation of a diversification method, do not suffer from this difficulty.