Risk Allocation, Factor Investing And Smart Beta: Reconciling Innovations In Equity Portfolio Construction

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. 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.