Scientific Beta Multi-Strategy Factor Indices: Combining Factor Tilts and Improved Diversification

This paper by EDHEC argues that current smart beta investment approaches only provide a partial answer to the main shortcomings of cap-weighted indices, and introduces Scientific Beta Multi-Strategy Factor Indices which are constructed using a new approach to equity investing referred to as smart factor investing.

It then provides an assessment of the benefits of addressing the two main problems of cap-weighted indices (their undesirable factor exposures and their heavy concentration) simultaneously by constructing factor indices that explicitly seek exposures to rewarded risk factors, while diversifying away unrewarded risks.

The results suggest that ERI Scientific Beta Multi-Strategy 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 consistently outperform cap-weighted factor tilted indices, and factor indices from popular commercial index providers. Compared to 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 result as unintended consequences of ad hoc methodologies.

Read the full study here

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