Factor Investing and Adaptive Skill: 10 Observations on Rules-Based Equity Strategies

Abstract

There are many varieties of rules-based, or smart beta, equity strategies. In this article, we provide 10 insights that focus on the equity strategies that are currently the most commonly used among institutional investors: fundamental and low volatility. Rules-based strategy returns are largely driven by exposure to equity risk factors—especially value, small, and low volatility—but also momentum, quality, and several others. Several factors have produced above-market returns in the past, and there is reason to expect that they will do so over sufficiently long periods of time in the future. Factors will go through long periods of underperformance and require close monitoring. There are several ways to potentially profit from factor premiums, including traditional active strategies, timing strategies, and rules-based strategies. Using adaptive skill that adjusts strategy based on complex and changing market conditions is still the best way to exploit market inefficiencies. Asset allocation, not equity strategy, remains the most impactful portfolio decision. The right equity portfolio is dependent on an investor’s suitability factors, which include return objectives, tolerance for risk and cost, and oversight resources. Rules-based strategies are most attractive for investors with cost constraints, aversion to significant active risk from concentrated portfolios, or a desire to reduce market exposure at relatively low cost in the medium or long term through low-volatility investments.