@article {Amenc106, author = {No{\"e}l Amenc and Felix Goltz and Ashish Lodh and Lionel Martellini}, title = {Towards Smart Equity Factor Indices: Harvesting Risk Premia without Taking Unrewarded Risks }, volume = {40}, number = {4}, pages = {106--122}, year = {2014}, doi = {10.3905/jpm.2014.40.4.106}, publisher = {Institutional Investor Journals Umbrella}, abstract = {This article argues that current smart-beta investment approaches provide only a partial answer to the main shortcomings of capitalization-weighted indices and develops a new approach to equity investing, which the authors refer to as smart-factor investing. The authors then provide an assessment of the benefits of simultaneously addressing the two main problems of cap-weighted indices{\textemdash}their undesirable factor exposures and their heavy concentration{\textemdash}by constructing factor indices that explicitly seek exposures to rewarded risk factors, while diversifying away unrewarded risks. The results suggest that such smart-factor indices lead to considerable improvements in risk-adjusted performance. For long-term U.S. data, smart-factor indices for a range of different factor tilts consistently outperform cap-weighted, factor-tilted indices. Compared with the broad cap-weighted index, smart-factor indices roughly double the risk-adjusted return (Sharpe ratio). Outperformance of such indices persists at levels ranging from 2.92\% to 4.46\% annually, even when assuming unrealistically high transaction costs. Moreover, by providing explicit tilts to consensual factors, such indices improve upon many current smart-beta offerings where, more often than not, factor tilts exist as unintended consequences of ad hoc methodologies.TOPICS: Analysis of individual factors/risk premia, factor-based models, portfolio construction}, issn = {0095-4918}, URL = {https://jpm.pm-research.com/content/40/4/106}, eprint = {https://jpm.pm-research.com/content/40/4/106.full.pdf}, journal = {The Journal of Portfolio Management} }