Specifically, smart beta investors should identify those factors that they believe which they want exposure to; acknowledge that they are complementary and that pairs amongst them are not so highly correlated that including both would be unnecessary; and consider the methodology for combining the factors.
To start off, five academically-backed and historically-tested factors include value, size, momentum, quality and low volatility. These various factors found in many smart beta ETFs have undergone extensive empirical tests to show a history of long-term outperformance.
When analyzing the five factors, Deutsche Asset Management found two important features: First is the relatively uncorrelated nature of most of the pairs of factors. Secondly, there are stocks available that exhibit both characteristics, “confirming our earlier point about the non-mutually exclusive nature of factors.” Bush added.
Consequently, investors are ultimately left with a decision based on their risk tolerance. Too few factors risks leaving strong incremental drivers of equity returns left to chance while too many factors risks additional complexity for the sake of marginal excess return.
“Pick factor exposures that you believe in, and be aware of the trade-off between having too few, and having too many,” Bush said. “Ensure that your final choices are relatively uncorrelated so that needless factors aren’t included.”
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