Are Factor Investing and Smart Beta Identical? | Nicolas Rabener – Factor Research

Factor Investing has become more
popular over time, especially since the financial crisis
simply because investors realized that there is actually very little Alpha and most of it is just called systematic beta or factor exposure. Of
course investors do want to achieve outperformance so if you're benchmarked
against that S&P500. and the S&P500 is up ten percent
it would be great if you have eleven percent. Now finding fund managers that
generate that extra 1% that you want… that's actually quite challenging.
Factors have shown over the long term, especially if you combine several
factors, that they do allow to outperform an index and that's why they
have increased in popularity. They're the only source of returns that do allow to
outperform the index. It doesn't matter which asset class. One way of explaining
why factors work why they should generate excess returns is that they do
represent risks. And you get effectively compensated for holding them, once
in a while the risk actually takes place there's a drawndwn but over a long time you
can harvest those returns. Factor investing comes from the academic world versus
smart beta is a practical application. Smart beta is nothing than factor
investing in a long only form. So effectively what companies like Blackrock or Vanguard do is: take the S&P 500 and tilt it towards
certain factors. Someone wants to take advantage of the value factor? They can
look for a 'Smart Beta Value ETF'. It's very important to note that there's
a big discrepancy between theory and reality. So what most investors who are
interested in factor investing do is: they tend to read academic research or at least
read what other people are summarizing about the research. What you see is
those returns being published in journals and for example the value factor
giving XYZ present return. Now what unfortunately has happened is that you take the
investment products that most investors have access to, such as retail investors in smart beta ETFs. The returns they get out of those are often a fraction of what you see in academic journals so it's a big disconnect between what people are
reading and what people are getting and that's something worth highlighting. The
opportunity set that investors have especially on the retail side is just
so much more narrow than what you have on the institutional side, where you can
replicate structures that are more similar to what you read in academic

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