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- Smart beta indices are a popular tool to gain factor exposure
- However, many do not provide as much factor exposure as one might expect
- They also fail to unlock the full potential of factor premiums

We take the value, momentum, profitability and investment portfolios directly from the online data library of Kenneth French. The low-volatility strategy is not provided by Kenneth French and therefore self-constructed, following a similar methodology.

The portfolios are considered on a capitalization-weighted as well as on an equally weighted basis. A simple, equally weighted combination of value, momentum and low-volatility factor portfolios results in a Sharpe ratio of 0.49, versus 0.32 for the market cap-weighted portfolio. The Sharpe ratio can be improved further to 0.58 by using equally weighted instead of cap-weighted factor portfolios. By adding profitability and investment factor portfolios to the mix these Sharpe ratios are not improved further, but information ratios do go up, i.e. market-relative performance improves.

As for the smart beta indices, we use the Russell 1000 Value index and the MSCI Value Weighted index for the value factor. For the momentum factor we take the MSCI Momentum index. For low-volatility we take the S&P Low Volatility index. Indices that specifically target the new profitability and investment factors do not seem to be available, but instead we consider two indices that are quite popular in practice: the MSCI Quality index and the MSCI High Dividend index. For the market portfolio we use the standard index of MSCI.

Source: MSCI, S&P, Russell, Kenneth French & Robeco

Table 1 also shows that a substantial part (73%) of the performance of the MSCI Momentum index is attributable to the Momentum factor portfolio. The remaining weight goes to the market portfolio. The S&P Low Volatility loads heavily on the Low Volatility factor portfolio (71%), combined with a bit of value exposure. These figures suggest that the indices are quite suitable for obtaining momentum and low-volatility factor exposure, but do not offer maximum exposure to these factors.

Although the MSCI High Dividend index outperforms its replicating portfolio of factor strategies with over 1% per annum, the outperformance is statistically insignificant, which implies that there is insufficient evidence for added value beyond classic low-volatility and value factor exposure. The performance of the other smart beta indices is also in line with their factor replication portfolios. The one exception is the S&P Low Volatility index, which shows an economically large (over 2% per annum) and statistically significant outperformance. This outperformance disappears entirely though if we also include equally-weighted factor portfolios in the analysis, as shown in Table 2. In this case we find 84% exposure to the equally-weighted Low Volatility factor portfolio, plus another 8% exposure to the value-weighted Low Volatility factor portfolio, and a performance difference which is close to zero.

Source: MSCI, S&P, Russell, Kenneth French & Robeco

From Table 2 we can also conclude that most of the performance of the other smart beta indices is not attributable to equally weighted factor portfolios, since most of the weight still goes to the cap-weighted factor portfolios. As equally-weighted factor portfolios show a better performance than cap-weighted ones, this suggests that smart beta indices may not unlock the full potential offered by factor premiums.

Smart beta indices may not unlock the full potential of factor premiums, because in most cases they seem to be exposed to cap-weighted factor strategies, while equally-weighted factor strategies are known to generate higher returns. Altogether, these results imply that smart beta indices may be used to harvest generic factor premiums, but also that it is crucial to properly understand the characteristics of these indices in order to obtain the desired amount of exposure to each particular factor, and the intended portfolio risk-return profile.

For more detailed information on the research, please read the paper ‘Factor investing with smart beta indices’ on SSRN.

“Factor investing, aimed at systematically capturing the value, momentum, low-volatility and other premiums, holds the future.”

- Related subjects:
- equities,
- factor investing,
- low volatility,
- momentum factor,
- quant,
- smart beta,
- value factor,
- David Blitz, PhD

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