Scientific Beta

A recent article by Hunstad and Dekhayser (Journal of Index Investing, Summer 2015) introduced a novel measure of factor "purity"—the factor efficiency ratio—and concluded that the indexes analyzed "were generally unable to provide desired factor exposures without taking on substantial unintended exposures" and that indexes are not "pure" in their delivery of intended factor exposures. This note, published in the Summer 2016 issue of the Journal of Index Investing, points out several questions regarding the relevance of factor efficiency ratios and similar assessments of purity of factor indexes.

An article by Hunstad and Dekhayser in the Summer 2015 issue of The Journal of Index Investing introduced a novel measure of factor "purity" termed the factor efficiency ratio (FER). For any given portfolio, this measure is defined as the ratio of the active risk contribution of desired factors to the total active risk of the portfolio. The article then applied the novel FER measure to a range of "smart beta" indexes with data for index holdings as of December 2013, using a proprietary factor modeling software from Barra. The article concluded that the indexes analyzed "were generally unable to provide desired factor exposures without taking on substantial unintended exposures" and that these indexes were "not 'pure'" in their incremental delivery of intended factor exposures. This note, published in the Summer 2016 issue of the Journal of Index Investing, points out several questions regarding the relevance of factor efficiency ratios and similar assessments of purity of factor indexes.