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10 Insights on Rules-Based and Factor Investing

10 Insights on Rules-Based and Factor Investing

Key Points


  • There are many varieties of rules-based, or “smart beta,” strategies. In this article, we focus on the equity strategies1 that are currently the most commonly used among institutional investors: fundamental and low volatility.
  • Rules-based strategy returns are largely driven by exposure to equity risk factors—especially value, small, and low volatility—but also momentum, quality, and several others.
  • Several factors have produced above-market returns in the past, and it is reasonable to expect that they will do so over sufficiently long periods of time in the future.
  • Factors will go through long periods of underperformance and require close monitoring.
  • There are several ways to potentially profit from factor premiums, including traditional active strategies, timing strategies, and rules-based strategies.
  • Using an “adaptive” skill that adjusts strategy based on complex and changing market conditions is still the best way to exploit market inefficiencies.
  • We believe asset allocation, not equity strategy, is the most impactful portfolio decision.
  • The right equity portfolio is dependent on your suitability factors, which include return objectives, tolerance for risk and cost, and oversight resources.
  • Rules-based strategies are most attractive for investors with cost constraints, aversion to significant active risk from concentrated portfolios, or a desire to reduce market exposure at relatively low cost in the medium or long term through low-volatility investments.

10 Insights on Rules-Based and Factor Investing: Facts and Strategies You Can Use in Constructing the Right Portfolio for You


10. Rules-based investing, or “smart beta,” returns are mostly driven by exposure to risk factors Traditional indexes weight stocks by market capitalization: the market value of outstanding stock. Rulesbased portfolio strategies—now often referred to as “smart beta” (we use the terms interchangeably in this paper)—weight stocks by something other than market cap. The simplest non-market cap way of weighting stocks is equal weighting, but that strategy requires holding equal weights in the very smallest stocks, which may be hard to trade. So, most smart beta indexes use something else to weight stocks— i.e., a transparent, rules-based approach. They deviate from traditional cap-weighted indexes by reweighting stocks in a systematic manner based on well-defined factors such as relative price/earnings, relative volatility, momentum, quality, and other risk-based or market segment criteria.

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