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Factor Investing and Risk Management: Is Smart-Beta Diversification Smart?

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  • Nazaire, Gregory
  • Pacurar, Maria
  • Sy, Oumar

Abstract

In this paper, we investigate the diversification benefits associated with factor investing in U.S. stock markets, using the dummy-variable framework for asset allocation. We find that beta-based investment strategies are primarily driven by beta-specific sources of return variation. At the same time, both betas and characteristics explain the variance of characteristic-based strategies, indicating that beta diversification is a more effective risk management tool than characteristic diversification. We also find that the correlations between the pure premiums of the 14 factor-based strategies considered are small, which suggests that diversification across smart-beta funds is beneficial. Monte Carlo simulations confirm these results.

Suggested Citation

  • Nazaire, Gregory & Pacurar, Maria & Sy, Oumar, 2021. "Factor Investing and Risk Management: Is Smart-Beta Diversification Smart?," Finance Research Letters, Elsevier, vol. 41(C).
    • Handle: RePEc:eee:finlet:v:41:y:2021:i:c:s1544612320316688
    DOI: 10.1016/j.frl.2020.101854
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    Cited by:

    1. Mbengue, Mohamed Lamine & Ndiaye, Bara & Sy, Oumar, 2023. "Which factors explain African stock returns?," Finance Research Letters, Elsevier, vol. 54(C).

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    More about this item

    Keywords

    Betas; Characteristics; Factor investing; Risk management;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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