Scientific Beta

In the latest smart beta special issue of the Practical Applications report from Institutional Investor Journals dated 30 November 2015, Noël Amenc, Felix Goltz, Ashish Lodh and Lionel Martellini of ERI Scientific Beta and EDHEC-Risk Institute offer a new approach to equity investing, referred to as smart factor investing, which uses smart factor indices that provide exposure to a rewarded factor while diversifying away unrewarded risks.

Well over 30% of investment professionals use products involving smart beta indices, but the existing crop of products meant to address the well-recognised shortcomings of cap-weighted indices fail to do the trick. Although risk-based and factor-based smart beta strategies are pitched as a way to avoid undesirable factor exposures and heavy concentrations, most of the current products do not meet that goal, according to the authors.

This approach was explored in an article entitled "Towards Smart Equity Factor Indices: Harvesting Risk Premia without Taking Unrewarded Risks", published in the Summer 2014 issue of The Journal of Portfolio Management. The results of that article 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.

This Practical Applications report consists of an easily comprehensible overview of the source article, a concise explanation of who will benefit from this research, and clear recommendations on how to apply the findings.