Evaluating the Efficiency of 'Smart Beta' Indexes

The past several years have witnessed the introduction of hundreds of so-called “smart beta” equity indices. These indices provide exposure to risk factors, such as value or low volatility, in order to seek excess return and/or risk reduction compared to cap-weighted indices. Although the set of risk factors that these indices target is relatively small, construction methodologies and historical performance have varied significantly, even among those indices seeking exposure to exactly the same factors. In this article, we introduce a simple metric we call the factor efficiency ratio that gauges the amount of active risk an index product derives from intentional, desired factor exposure versus active risk stemming from unintended or undesired bets. This ratio is a measure of how efficiently an index targets a group of intended factors and we demonstrate the strong relationship between efficiency and risk-adjusted returns. In doing so, we also highlight several potential problems with the design of existing smart beta indices