Smart Beta or Factor Investing?

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Our new paper in the Journal of Asset Management shows how portfolios of multiple Smart Beta indices can be replaced by more efficient robust portfolios with targeted factor exposures.

We were amongst the first to highlight that Smart Beta strategies can be explained by exposures to factors such as value, low volatility, size and momentum. In our Spring 2012 paper in the Journal of Portfolio Management1 we demonstrated that a class of Smart Beta strategies known as Risk-Based strategies, which include Minimum Variance, Maximum Diversification and Risk Parity, can be almost fully explained by their exposures to the low volatility factor and in the case of Risk Parity also to the size factor and to a smaller extent the value factor.

This evidence has been confirmed by a number of other researchers since then. Fundamental Indexing, another type of Smart Beta strategy, has also been shown to derive its excess returns from exposures to factors, in particular the value factor.

If a portfolio of multiple Smart Beta indices earns excess returns from multiple factor exposures why not just build a robust portfolio with the desired factor exposures? One big advantage is that, since there is only a handful number of known factor anomalies worth investing in, that makes life much easier than analysing and selecting from hundreds of Smart Beta indices available today. The other is that investors can decide what factors to include in their portfolios and what risk exposures to those factors they should aim at.

This is what our new paper in the latest issue of the Journal of Asset Management2 addresses. We show how investors can build robust portfolios with the desired factor exposures. The framework we propose can handle constraints in a transparent way and the empirical results demonstrate it is efficient at controlling for the factor risk exposures and at retaining the factor premiums even after applying constraints.

1 Raul Leote de Carvalho, Xiao Lu, and Pierre Moulin. “Demystifying Equity Risk–Based Strategies: A Simple Alpha plus Beta Description.” Journal of Portfolio Management. Vol. 38, No. 3 (2012), pp. 56-70.

2 Raul Leote de Carvalho, Xiao Lu and Pierre Moulin. “An integrated risk-budgeting approach for multi-strategy equity portfolios.“  Journal of Asset Management. Vol. 15, (2014), pp: 24-47.

Raul Leote de Carvalho

Deputy Head of Financial Engineering at BNP Paribas Investment Partners

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