Research

Index Design & Transaction Costs

In order to maximize the benefits of factor premiums, smart beta strategies should be thoughtfully constructed to minimize turnover and the subsequent transaction costs.

Poor index design can cannibalize returns

As smart beta has grown in popularity, so have the number of (positive) backtests and resulting product offerings. But these backtests and new indices often fail to consider the very real consequences of poor index design, which can significantly cannibalize returns through high transaction costs. Our research shows that over the last quarter-century the real-world return for the value and market factors is halved or worse than the returns theoretical factors imply, and the momentum factor has provided no benefit whatsoever to the end investor. Despite this, many investors overlook the concept of index design.

Thoughtful index design is necessary to maximize benefits of factor premiums

At RAFI Indices, we emphasize the importance of index design and its impact on turnover, transaction costs, and capacity to ensure that our strategies are able to capture the maximum benefits of factor premiums.

Further Insights

Research Affiliates, our sister company, has published a number of articles on factor investing to help investors
determine if a factor is robust and to understand the inherent risks in factor investing.

Strike the Right Balance in
Multi-Factor Strategy Design

Investors should not ignore the presence of real-world implementation challenges in selecting a multi-factor smart beta strategy. Thoughtful design in multi-factor investing requires a conscious and deliberate decision to find the most advantageous balance between effectively harvesting the factor premium and the costs of implementation.

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Transaction Costs
of Factor-Investing Strategies

Although hidden, the implicit market impact costs of factor investing may substantially erode a strategy’s expected excess returns. The rebalancing data of a suite of large and long-standing factor-investing indices are used in this study to model these market impact costs. Published in the Financial Analysts Journal.

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Trade-Off in Multifactor Smart Beta Investing: Factor Premium and Implementation Cost

The authors study the impact of the inclusion of the momentum and size factors, and the selectiveness in stock screening, on the performance and implementation cost of a multifactor strategy. Published in the Journal of Portfolio Management.

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Costs and Capacity: Comparing Smart Beta Strategies

The significant growth in smart beta investing leads to potential alpha erosion when trading volume affects security prices. Our research shows how market impact costs due to rebalancing affect the capacities of popular strategies.

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Craftsmanship in Smart Beta

While somewhat at odds with today’s big-data, warp-speed approach to life and work, thoughtful craftsmanship—the product design and implementation elements that are tangible, measurable, and impactful—can create positive, persistent results in portfolio performance

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The Dirty Little Secret
of Passive Investing

Passive investments have hidden costs in the form of forgone performance due to transactions occurring at prices that would not have prevailed if index-tracking managers didn’t need to enter trades. Read how implicit trading costs affect results.

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