Specifically, the average Sharpe ratio across the six factor tilts based on diversified multi-strategy indices is 0.56, compared to an average Sharpe ratio of 0.43 for market cap-weighted factor tilts. The Sharpe ratio is a measure for calculating risk-adjusted return, and a higher value typically reflects a more attractive risk-adjusted return.
“It appears that the combined effects of a rewarded factor exposure ensured by a dedicated proper security selection process and efficient harvesting of the associated premium through improved portfolio diversification leads to considerable Sharpe ratio improvements compared to the broad cap-weighted index,” according to the research paper. “In a nutshell, an improved weighting scheme which focuses on diversification such as diversified multi-strategy weighting allows unrewarded risks to be diversified away.”
[related_stories]A well-diversified index based on multiple factors is at the core of the so-called smart-beta 2.0 approach advocated by Scientific Beta. For instance, ETF Securities has partnered with ERI Scientific Beta on the ETFS Diversified-Factor U.S. Large Cap Index Fund (NYSEArca: SBUS) and ETFS Diversified-Factor Developed Europe Index Fund (NYSEArca: SBEU). The two ETFs’ selection process includes emphasizing investment factors, such as volatility, valuation, momentum and size.
The ETFS Diversified-Factor U.S. Large Cap Index Fund and ETFS Diversified-Factor Developed Europe Index also use a proprietary weighting strategy to provide well diversified exposure, by combining 5 models: Maximum Deconcentration, Maximum Decorrelation, Efficient Minimum Volatility, Efficient Maximum Sharpe Ratio, and Diversified Risk Weighted.
Related: ETF Investing in the World of the Impossible and Inevitable
The alternative weighting methodologies have been working out so far as SBUS has gained 5.1% year-to-date, outperforming the S&P 500 3.1% increase. SBEU is down 0.6% year-to-date, but it is still outperforming the Stoxx Europe 50 Index, which is down 5.7%.
Additionally, Global X offers a line of scientific beta ETFs that are based off EDHEC-Risk Institute indices that target multiple factors, including low-volatility, momentum, size and value. The indices also combine the five models, including Maximum Deconcentration, Maximum Decorrelation, Efficient Minimum Volatility, Efficient Maximum Sharpe Ratio, and Diversified Risk Weighted.
The Global X options include the Global X Scientific Beta US ETF (NYSEArca: SCIU), Global X Scientific Beta Europe ETF (NYSEArca: SCID), Global X Scientific Beta Asia ex-Japan ETF (NYSEArca: SCIX) and Global X Scientific Beta Japan ETF (NYSEArca: SCIJ). Year-to-date, SCIU was up 4.2%, SCID was down 0.8%, SCIX rose 5.1% and SCIJ added 0.9%.
Despite their decent performances, these smart-beta ETFs have not attracted as much interest from the investment community, so potential investors should utilize limit orders to better control trades.
For more news and strategy on the Smart-Beta ETF market, visit our Smart-Beta category.