Scientific Beta

This article, published in the Summer 2014 issue of the Journal of Portfolio Management, argues that current smart-beta investment approaches only provide a partial answer to the main shortcomings of capitalization-weighted indices, and develops a new approach to equity investing, which the authors refer to as smart-factor investing. The authors then provide an assessment of the benefits of simultaneously addressing the two main problems of cap-weighted indices - 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 suggest that such smart-factor indices lead to considerable improvements in risk-adjusted performance.

This article, published in the Summer 2014 issue of the Journal of Portfolio Management, argues that current smart-beta investment approaches only provide a partial answer to the main shortcomings of capitalization-weighted indices, and develops a new approach to equity investing, which the authors refer to as smart-factor investing. The authors then provide an assessment of the benefits of simultaneously addressing the two main problems of cap-weighted indices - 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 suggest that such smart-factor indices lead to considerable improvements in risk-adjusted performance. For long-term U.S. data, smart-factor indices for a range of different factor tilts consistently outperform cap-weighted, factor-tilted indices. Compared with the broad cap-weighted index, smart-factor indices roughly double the risk-adjusted return (Sharpe ratio). Outperformance of such indices persists at levels ranging from 2.92% to 4.46% annually, 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 exist as unintended consequences of ad hoc methodologies.