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F actor investing and smart beta strategies are in vogue. A recent survey of major investors reports that almost three-quarters of asset owners are already using or are actively evaluating smart beta (FTSE Russell [2016]). Of those with an allocation to smart beta, nearly two-thirds are evaluating additional allocations, and the proportion of asset owners using at least five smart beta indexes has risen tenfold, from 2% in 2014 to over 20% in 2016. These market participants, with over USD 2 trillion in assets, include corporations, governments, pension plans and nonprofit organizations, and they have adopted factor investing as an integral part of their strategy.
Exchange-traded funds (ETFs) and exchange-traded products (ETPs) have opened up further opportunities for investors to target asset exposures selectively. By the end of 2016, there were over 6,000 ETFs and ETPs, with over 12,000 listings and assets totaling USD 3.5 trillion; see Fuhr [2017]. There were over 1,000 smart beta equity products, with over 2,000 listings and assets totaling over USD 0.5 trillion. There were 145 smart beta equity providers in 32 different countries. Smart beta investing seeks to harvest the long-run factor premiums highlighted by academic researchers. Factors are the security-related characteristics that give rise to common patterns of return among subsets of listed securities. While industry and sector membership have long been a part of how we categorize investments, our focus here is on attributes that go beyond industry membership.
To identify factors, researchers typically construct long-short portfolios. These portfolios are long the preferred exposure and short the unwanted exposure. In the equity market, for example, an income factor portfolio would contain higher-dividend yield stocks accompanied by a short position in lower-yielding stocks. It is far easier to buy stocks you do not own than to sell stocks you do not own. So the long side of a factor portfolio is usually easy to acquire, whereas the short side can be challenging. Long-short strategies are therefore relatively expensive--on occasion impossible--to construct, and they can certainly be difficult to scale up. "Pure play" long-short strategies are sometimes called "style strategies."
It should be no surprise that the growth in smart beta ETFs and ETPs is in long-only portfolios that are tilted (sometimes rather modestly) toward or away from particular...