Scientific Beta

This publication argues that current smart beta investment approaches only provide a partial answer to the main shortcomings of capitalisation-weighted (cap-weighted) indices, and develops a new approach to equity investing referred to as smart factor investing. It provides an assessment of the benefits of simultaneously addressing the two main shortcomings of cap-weighted indices, namely their undesirable factor exposures and their heavy concentration, by constructing factor indices that explicitly seek exposures to rewarded risk factors while diversifying away unrewarded risks. The results we obtain suggest that such smart factor indices lead to considerable improvements in risk-adjusted performance.

This publication argues that current smart beta investment approaches only provide a partial answer to the main shortcomings of capitalisation-weighted (cap-weighted) indices, and develops a new approach to equity investing referred to as smart factor investing. It provides an assessment of the benefits of simultaneously addressing the two main shortcomings of cap-weighted indices, namely their undesirable factor exposures and their heavy concentration, by constructing factor indices that explicitly seek exposures to rewarded risk factors while diversifying away unrewarded risks.

The results we obtain suggest that such smart factor indices lead to considerable improvements in risk-adjusted performance. For long-term US data, smart factor indices for a range of different factor tilts roughly double the Sharpe ratio of the broad cap-weighted index. Outperformance of such indices persists at levels ranging from 2.92% to 4.46%, even when assuming unrealistically high transaction costs. Moreover, by providing explicit tilts to consensual factors, such indices improve upon many current smart beta offerings where, more often than not, factor tilts result as unintended consequences of ad hoc methodologies. In fact, this publication shows that by using consensual results from asset pricing theory concerning both the existence of factor premia and the importance of diversification, it is possible to go beyond existing smart beta approaches which provide partial solutions by only addressing one of these issues.