Smart Beta Efficiency versus Investability : Introducing the Cost-Adjusted Factor Efficiency Ratio

With an increasing number of smart beta strategies that track the same factor in the marketplace, it is more important than ever to understand the underlying drivers of risk and return of these strategies, which can vary greatly. This is because the underlying portfolio construction of these strategies determines risk and return and, ultimately, the factors to which a portfolio is exposed. Portfolio construction also determines how investable a strategy is, and this is often manifested through both financial and non-financial costs. For example, consider two strategies that are all but identical except their rebalance frequency. The strategy that rebalances more frequently may have a higher factor exposure, but it is also likely to rack up higher transaction costs. For this reason, if having the maximum possible factor exposure is one of the portfolio objectives, then looking at factor exposure via a risk model may be useful in understanding how much risk exposure you obtain from a strategy — but this should be seen in the context of how much cost is incurred in the process of achieving that exposure.To that end, we have come up with the cost-adjusted factor efficiency ratio (ca-FER), which seeks to address this trade-off. This new metric is built on Hunstad and Deskahyer (2015)'s factor efficiency ratio (FER), and it may be used in conjunction with other criteria that are already at the disposal of market participants to judge smart beta portfolios.We demonstrate the potential application of this metric through detailed case studies analyzing single-factor and multi-factor long-only portfolios, which are built using both ranking- and optimization-based construction techniques. We further examine the merits of building concentrated factor portfolios vis-à-vis diversified portfolios