Efficient Smart Beta

Abstract

Investors are increasingly interested in portfolios that are not cap-weighted and that give exposure to specific factor premiums, which we call smart beta portfolios. In this article, we focus on the asset weighting used in smart beta portfolios and show that risk balancing when building factor exposure portfolios yields the most efficient capture of the factor exposure premium. This efficiency comes from both adequate intended factor exposure, which captures positive factor risk premium, and reduced risk concentration in unintended factors, which comes directly from the risk balancing. Other commonly used weighting schemes tend to have less efficient factor premium capture due in part to these unintended risk concentrations, which enter the portfolio because risk is not explicitly taken into account when weighting the assets.