Deconstructing Smart Beta

February 10, 2015

Implementation Issues to Consider
In addition to the implementation issues previously identified, the following points should be taken into account.
Short selling:
Long-short risk premia strategies make extensive use of shorting and leverage. However, it may become prohibitive or even impossible to short securities in times of crisis, as illustrated in the lending spreads of the S&P 500, S&P MidCap 400® and S&P SmallCap 600® as shown in Exhibit 9. In general, the securities’ lending spreads aim to reflect the difference between the funding rate and the average securities’ lending rate for the reference equity index.
They are used to approximate the true cost to borrow. Evidently, the less liquid a stock is, the higher the potential cost of borrowing. In addition, some investors in certain countries may not be permitted to use derivatives to take short positions. Without derivatives, implementing a short position may be costly and impractical.
High transaction costs:
The extensive use of short selling, leverage, the need for regular rebalancing given the volatile nature of the factors, and the low capacity of some factors, may lead to high transaction costs that may erode the returns of these risk premia strategies in practice.
Unstable correlations between factors:
One of the cornerstones underlying the concept of risk premia strategies is the low correlation between factors. However, factor correlation can be volatile and unstable. Exhibit 10 shows the rolling three-year correlations of four factors. For example, the correlation between small cap and equity value ranged from -0.13 to 0.66.
Many systematic risk premia strategies follow simple weighting schemes, such as equal weight, volatility weight or risk parity weight. This may result in overweighting underperforming factors and underweighting outperforming factors.

Conclusion
In this paper, we explored two approaches to incorporating risk factors into asset allocation and portfolio construction. The first approach involved enhancing returns and reducing risk using alternate beta building blocks; and the second examined constructing an absolute return portfolio using risk premia building blocks.
Alternate beta or factor-based investing is becoming a viable way of constructing institutional portfolios. The approach can either seek to enhance return or reduce risk, or both. In this paper, the challenges institutional investors face in their decision-making and implementation were highlighted.

 

Find your next ETF

Reset All