Evaluating the Efficiency of 'Smart Beta' Indexes

The Journal of Index Investing. Summer 2015, Vol. 6, No. 1: pp. 111-121

Posted: 18 Oct 2014 Last revised: 28 May 2015

See all articles by Michael Hunstad

Michael Hunstad

Northern Trust Asset Management

Jordan Dekhayser

Northern Trust Asset Management

Date Written: February 28, 2015

Abstract

The past several years have witnessed the introduction of hundreds of so-called “smart beta” equity indices. These indices provide exposure to risk factors, such as value or low volatility, in order to seek excess return and/or risk reduction compared to cap-weighted indices. Although the set of risk factors that these indices target is relatively small, construction methodologies and historical performance have varied significantly, even among those indices seeking exposure to exactly the same factors. In this article, we introduce a simple metric we call the factor efficiency ratio that gauges the amount of active risk an index product derives from intentional, desired factor exposure versus active risk stemming from unintended or undesired bets. This ratio is a measure of how efficiently an index targets a group of intended factors and we demonstrate the strong relationship between efficiency and risk-adjusted returns. In doing so, we also highlight several potential problems with the design of existing smart beta indices.

Keywords: Factor Investing, Smart Beta, Risk Premia, Low Volatility, Dividend Yield, Value

JEL Classification: G10, G11, G12, G14

Suggested Citation

Hunstad, Michael and Dekhayser, Jordan, Evaluating the Efficiency of 'Smart Beta' Indexes (February 28, 2015). The Journal of Index Investing. Summer 2015, Vol. 6, No. 1: pp. 111-121. Available at SSRN: https://ssrn.com/abstract=2510987 or http://dx.doi.org/10.2139/ssrn.2510987

Michael Hunstad

Northern Trust Asset Management ( email )

50 South LaSalle Street
Chicago, IL 60603
United States

Jordan Dekhayser (Contact Author)

Northern Trust Asset Management ( email )

50 South LaSalle Street
Chicago, IL 60603
United States

Register to save articles to
your library

Register

Paper statistics

Abstract Views
1,959
PlumX Metrics