Towards Smart Equity Factor Indices: Harvesting Risk Premia without Taking Unrewarded Risks

Abstract

This article argues that current smart-beta investment approaches provide only a partial answer to the main shortcomings of capitalization-weighted indices and develops a new approach to equity investing, which the authors refer to as smart-factor investing. The authors then provide an assessment of the benefits of simultaneously addressing the two main problems of cap-weighted indices—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 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. TOPICS: Analysis of individual factors/risk premia , factor-based models , portfolio construction

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