Smart beta portfolio construction - Build a mixed portfolio with some timing

Once there is an understanding of how the risk premia are constructed, investing in (long-only) factors or smart beta portfolios does not have to be difficult. From a core portfolio of different asset class betas, an investor can add further diversification through increasing exposure to other risk premia like momentum, size, value, quality or low volatility. Combination of smart betas can still generate market equity returns but with a different risk profile. 

A simple educational piece "Blending Factors in Your Smart Beta Portfolio" by the researchers at S&P Dow Jones Indices shows that blended portfolios of defensive and pro-cyclical smart beta indices can generate alpha relative to the market index. Centered aat the market beta, it can be seen that different factor portfolios generally have improved return to risk profiles even versus a levered market portfolio. The dispersion of risk and return means there can be further gains from blending factors.

The value of factor blending can be seen through their low correlation across factors. A fair number of factors actually have negative correlation. Note, however, that these correlations are not stable. During times of market stress, there are significant divergences in return relationships especially between factors that are viewed as defensive versus those that are viewed as pro-cyclical. There is room for factor portfolio adjustments especially during periods of stress.

This research piece also address the controversial issue of timing factors in a simple way. Using a trend-following model that adjusts on a quarterly basis, the authors measure the gain from trend timing when you choose the factor with the highest momentum ranking followed by the second highest ranking and so forth. The analysis shows that using even some simple trend management will provide added returns. Interestingly choosing the best trend from a set of factors will not get you the highest cumulative return. However, any combination of factor trends will do better than the market portfolio. 

Factor investing still needs careful attention. There are underperformance periods that can last for years. For example, the core value risk premium, which has a strong economic rationale, has underperformed for an extended period. Nevertheless, combining these smart beta factor indices with some notion of performance timing can generate effective returns versus a market index.