Scientific Beta

This issue introduces Scientific Beta’s new Market+ solution offering both performance and sustainability objectives, presents a novel risk management technique enabling investors to mitigate the economic risks associated with diversified multi-factor strategies while preserving their benefits, highlights the importance of economic risks in driving equity portfolio returns, discusses new approaches to Quality and Defensive investing designed to address their typical biases, examines factor investing in emerging markets, and looks at a three-step approach for designing multi-factor strategies that address both sides of the climate transition.

The latest "Scientific Beta" special issue of the Research for Institutional Money Management supplement to Pensions & Investments first introduces Scientific Beta’s new Market+ solution, which enables investors to pursue both performance and sustainability objectives while closely aligning their portfolios with the market cap benchmark and respecting their relative risk budget constraint. In particular, we emphasize the importance of the use of objective-based sustainability metrics as opposed to subjective ESG scores, the use of evidence-based performance return drivers, such as consensus rewarded factors, and the use of a reliable and transparent risk management framework.

We then present a novel risk management technique, which enables investors to mitigate the economic risks associated with diversified multi-factor strategies while preserving their benefits, namely attractive Sharpe ratio relative to the market cap benchmark. This is achieved via a new weighting scheme called EconRisk, which enables the reduction of unnecessary tracking error due to unintended exposures to economic risks, thereby improving the efficiency of diversified multi-factor portfolios, as measured by the factor intensity per unit of tracking error.

We then highlight the importance of economic risks in driving equity portfolio returns. Indeed, we show that economic risks play a significant role, driving approximately one-third of the variation in equity portfolio returns beyond what is explained by the market and consensus rewarded factors, especially during turbulent periods, justifying their explicit management in factor strategies.

The next two articles discuss new approaches to Quality and Defensive investing which are designed to address their typical biases. We present a Quality strategy that relies on robust quality definitions, such as profitability and investment factors, that avoids quality traps by making sure stocks with poor valuations or low momentum are not selected and by targeting a stable market beta close to unity to smooth performance across market cycles. We then introduce a Defensive strategy that avoids implicit bets associated with traditional defensive strategies, such as unintended sector and regional biases or overweighting stocks with unfavorable characteristics. Scientific Beta’s Defensive Equity indices aim to mitigate these biases by strategically avoiding implicit bets, protecting capital, reducing extreme losses, and delivering superior risk-adjusted returns over the long term.

We then examine factor investing in emerging markets, highlighting the potential of a robust diversified multi-factor strategy to deliver strong risk-adjusted performance. The article discusses a four-step investment process based on six validated equity factors (value, momentum, size, low volatility, profitability, and low investment), emphasizing their low correlations and ability to provide a smoother ride for investors.

Finally, we discuss a three-step approach for designing multi-factor strategies that address both sides of the climate transition by reducing climate transition risk exposure and investing in climate solutions while preserving factor characteristics. In particular, we introduce an objective and forward-looking metric, solely based on market prices, namely the climate transition risk beta that we use in addition to carbon intensity to address the climate transition risk of the multi-factor portfolio.