EC HH Smart Beta Asset Allocation: A Preliminary Test

In theory, there’s a strong case for building portfolios based on risk factors. In practice, the jury’s out.

The transition from academic research to real-world portfolios, as usual, is a rocky affair. The results you achieve will depend on the factors you hold (and don’t hold), the funds you select to represent the factors, the weights you assign the factors, and the rebalancing schedule. Given that a huge range of portfolio designs are possible from adjusting those variables, it’s not surprising that results will vary, perhaps dramatically.

As a simple test, let’s build a smart-beta portfolio using ETFs and compare the results with a conventional S&P 500 ETF. As a preview, the results don’t look encouraging: the multi-risk-factor portfolio more or less tracks the S&P. That may be due to the naïve design of the factor portfolio, which we’ll define in a minute. But as a first step in exploring how an ETF-based factor portfolio performs let’s begin with a strategy that’s intuitive in the sense that it throws together a broad mix of the obvious risk exposures via the following eight funds:

* iShares Edge MSCI Min Vol USA (USMV) – low-volatility
* Vanguard High Dividend Yield ETF (VYM) – high-dividend yields
* Guggenheim S&P 500 Equal Weight ETF (RSP) – small-cap bias within large-cap space
* iShares Edge MSCI USA Quality Factor (QUAL) – so-called quality stocks
* iShares Edge MSCI USA Momentum Factor (MTUM) – price momentum
* iShares S&P Small-Cap 600 Value (IJS) – small-cap value stocks
* iShares S&P Mid-Cap 400 Value (IJJ) – mid-cap value stocks
* iShares S&P 500 Value (IVE) – large-cap value stocks

The motivation for holding a broad set of factors rather than just one or two? Risk management. Some analysts recommend diversifying across risk factors, although not everyone agrees. The standard approach is to use, say, a small-cap value fund to supplement exposure to standard large-cap equity allocation to boost expected return. The question here is whether holding a broad allocation of different risk factors is superior to owning the stock market via a conventional index?

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Disclosure: None.

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