Scientific Beta introduces quality-based multi-factor indices

Dec 1st, 2015 | By | Category: Equities

ERI Scientific Beta, the smart beta indexing initiative spun out of EDHEC-Risk Institute, has announced the release of a new suite of multi-factor smart beta indices based around fundamental measures of quality, namely high profitability and low investment. The combination of these factors has culminated in the firm’s Quality Multi-Beta Indices, a rules-based investable index which could form the basis of exchange-traded funds.

Scientific Beta introduces quality-based multi-factor indices

Through a combination of profitability and low investment fundamental screens the Scientific Beta multi-factor indices target superior risk-adjusted returns.

According to Scientific Beta, the high profitability and low investment risk factors have been identified in academic literature as not only providing higher returns in the long-term, when compared to market cap-weighted benchmarks, but also having simple and straightforward economic explanations which provide reassurance on the robustness and persistence of the factors.

A company’s profitability can be observed through measures such as return on assets; these quality returns in turn drive earnings growth. Scientific Beta posit; however, that investors, on average, do not discern between high and low profitability when analysing growth firms, leaving high profitability companies trading at a relative discount. Low levels of investment reflects firms’ limited scope for projects, often the result of high cost of capital. Scientific Beta believe that investors under-price low investment firms due to expectation errors.

The new multi smart factor indices are an equal-weighted combination of two sub-indices, each based on one of the two “quality” factors. To create each sub-index, members of the eligible universe are ranked based on their quality criteria (i.e. high profitability and low investment) with the lowest half of each universe excluded. Scientific Beta then employ a complicated diversification technique which blends five weighting schemes (maximum deconcentration, maximum decorrelation, efficient minimum volatility, efficient maximum sharpe ratio, and diversified risk weighted diversification strategies) so as to diversify both firm- and weighting-scheme-specific risks.

Analysis over the past 10 years (31 December 2004 to 31 December 2014) shows the benefits of combining the high profitability and low investment factors, with the index outperforming MSCI World by 3.14% on an annual basis while displaying lower volatility (15.31% vs. 17.49%) and a lower maximum drawdown (49.98% vs. 57.46%).

The indices are constructed based on a variety of regions and are available in both regular and highly-liquid versions with or without sector and geographical neutrality.

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