Risk Allocation, Factor Investing and Smart Beta: Reconciling Innovations in Equity Portfolio Construction

Noël Amenc, Romain Deguest, Felix Goltz, Ashish Lodh, Lionel Martellini, Eric Shirbini: This publication argues that current smart beta investment approaches only provide a partial answer to the main shortcomings of capitalisation-weighted (cap-weighted) indices, and develops a new approach to equity investing referred to as smart factor investing.

Author(s):

Noel Amenc

Professor of finance at EDHEC Business School, director of EDHEC-Risk Institute, and chief executive officer of ERI Scientific Beta.

Romain Deguest

Senior research engineer at EDHEC-Risk Institute.

Felix Goltz

Head of Applied Research at EDHEC-Risk Institute.

Ashish Lodh

Senior Quantitative Analyst.

Lionel Martellini

Professor of finance at EDHEC Business School and scientific director of EDHEC-Risk Institute.

Eric Shirbini

Global Product Specialist with ERI Scientific Beta.

It provides an assessment of the benefits of simultaneously addressing the two main shortcomings of cap-weighted indices, namely 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 we obtain suggest that such smart 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 roughly double the Sharpe ratio of the broad cap-weighted index. Outperformance of such indices persists at levels ranging from 2.92% to 4.46%, 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. In fact, this publication shows that by using consensual results from asset pricing theory concerning both the existence of factor premia and the importance of diversification, it is possible to go beyond existing smart beta approaches which provide partial solutions by only addressing one of these issues. This research was produced as part of the "Core-Satellite and ETF Investment" research chair at EDHEC-Risk Institute, in partnership with Amundi ETF & Indexing.

Type: EDHEC Publication
Date: le 19/06/2014
Research Cluster : Finance

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