Optimal Blending of Smart
Beta and Multifactor Portfolios
T
Frederick E. Dopfel
is a professor in the
Barowsky School of
Business at Dominican
University of California
in San Rafael, CA.
fred.dopfel@dominican.edu
Ashley L ester
is global head of multi-
asset research at Schroders
in London, U.K.
ashley.lester@schroders.com
Quantitative Special Issue 2018
Frederick E. Dopfel and Ashley Lester
here has been extraordinary growth
in the use of smart beta funds by
institutional investors, both large
and small.1 Many investors have
strategically allocated assets away from tra-
ditional index and active equity funds into
multiple smart beta funds by balancing their
exposures across widely understood ideas,
such as value, small (size), momentum,
quality, and low volatility. Furthermore,
they have included more complex multifactor
funds that combine multiple smart beta ideas
into a single portfolio that arguably improves
efficiency.2 It is unlikely that the evolution of
these complex multifactor investments that we
call collectively advanced beta has resulted in
portfolios for which the cumulative exposure
is known or in any way ideal. Because one of
the important potential benefits of smart beta
investing is enhanced transparency of expo-
sures and risks, this is a key problem for its
users. Now, with the ever-increasing alloca-
tion to advanced beta products, investors need
guidance on how to construct an overall port-
folio that improves the likelihood of attaining
better investment outcomes.
The good news is that standard appro­
a­ches to investment performance analysis
and portfolio construction can be adapted to
integrate multiple smart beta approaches with
other assets. The first step is to understand
the underlying exposures of each smart
beta strategy and their correlations to other
strategies. We then need to be explicit about
our expectations for the performance of
each strategy, recognizing that an analyst’s
judgment is always required. Finally, proce-
dures for portfolio construction, built from
standard methods, can be used to optimize
expected utility for the investor, based on our
estimates and judgments.
With this approach, we are better
equipped to answer the following questions:
• How do we discern whether a new
smart beta fund may be a valuable
addition to the portfolio?
• When does a multifactor strategy add
value beyond a portfolio of simple factors?
• What is an efficient portfolio of smart
betas and advanced betas?
• When should smart beta and multifactor
portfolios be combined with traditional
indexes?
• How does the investment policy affect
the best allocation to advanced beta?
We begin with a framework to assess
the potential value-add of advanced beta
candidates and to establish forward-looking
assumptions. This provides the essential
information needed to understand the risk
and benefits of combining exposures. Next,
we define an objective function that leads
to the principles for optimal combinations
of smart betas and advanced betas. Finally,
The Journal of Portfolio M anagement    93
a case study demonstrates how the methodology can be
applied to attain better portfolios.
EVALUATING SMART BETA
AND ADVANCED BETA PORTFOLIOS
Smart beta refers to rule-based long-only market
exposures that are expected to yield risk-adjusted
returns in excess of the returns available with market-
capitalization-weighted indexes of standard asset classes.
Advanced beta, also called multifactor portfolios, refers to
portfolios that are constructed bottom up from several
smart betas or other factors. Like any other active expo-
sure, an individual smart beta or advanced beta strategy
may outperform or underperform the benchmark during
any period. Because of this variation, and the challenge
of timing individual smart betas, a blended portfolio
of smart betas makes good sense and has been recom-
mended by most analysts. However, this does not mean
that we should add every new smart beta to our portfolio.
We need a criterion to assess whether a new smart
beta is likely to be a value-add for the portfolio. Satis-
fying a value-add criterion involves two questions. First,
can we explain the performance of the candidate strategy
via strategies that are already available to us? Second, to
the extent that the candidate strategy does not dupli-
cate what is already available, is the additional (residual)
exposure attractive? Technically, we ask whether the
candidate strategy displays evidence of a positive alpha
after controlling for exposures from its normal portfolio.
A Factor Model Based on Elementary
Smart Betas
A practical way to answer these questions with
respect to new smart beta candidates is first to define
elementary smart betas (ESBs) as a small set of representa-
tions of smart beta that are readily investible and rep-
resent the factors that are most strongly supported by
long consensus of financial research. The ESB factors
are defined as the returns of an associated smart beta
index in excess of the broad market index returns. The
excess return of any advanced beta candidate strategy
then may be represented as a mix of asset class, smart
beta, and residual exposures, as follows:
rab = f b rb + ∑ i f esb,i resb,i + α ab (1)
94    Optimal Blending of Smart Beta and Multifactor Portfolios Quantitative Special Issue 2018
where rab is the excess return of the advanced beta candidate
over the market index; f b is the factor weight for market
index exposure associated with advanced beta; rb is the
market index (benchmark) return; f esb ,i are factor weights
for the ith ESB; resb ,i is the excess return of the ith ESB
factor; and α ab is the residual return. The tilde notation,
as in rb , refers to a random variable where the mean is rb
and the variance is σ b2. The factor weights are estimated
by returns-based style analysis (constrained regression)
overlaid with the analyst’s judgment.3 A strategy with
nonzero f b is referred to as leveraged ( f b > 0) or delever-
aged ( f b < 0). We would tentatively accept a smart beta
candidate in the presence of a sufficiently positive alpha,
but we otherwise reject the candidate.
Choice of Elementary Smart Betas
We initially define the elementary smart betas as
the Fama–French–Carhart set—value, small (size), and
momentum—which has been researched and practiced
over decades. We use the MSCI All Country World
Index (ACWI) versions of these three factors in this
article because these indexes are reasonable proxies for
relatively low-cost, low-tracking-error, investible repli-
cations of the SB indexes.4 Also, confirming many prior
studies, note that the value, small, and momentum active
returns are uncorrelated, with value and momentum
negatively correlated, supporting them as good initial
choices for elementary smart betas for this sort of factor
model.5 In practice, we have found that using these three
ESB factors is a reasonable approach for establishing a
normal portfolio, or effective asset mix, for a wide range of
smart beta and multifactor portfolios. Should the list of
elementary smart betas be expanded to include popular
smart betas like quality and low volatility? Possibly, but
the evidence suggests that quality and low volatility can
be approximated as combinations of the primary ESBs
in the context of a four-factor model.6 We leave open
the possibility that the set of ESBs may be redefined or
expanded in the future, as we develop more experience
with smart beta.
Selection Criteria and Model Assumptions
This factor model has two key properties: It serves
to evaluate new smart beta strategies and to provide
a foundation for blending several strategies. First, the
model highlights that, to be justified, a new strategy
should provide exposures beyond a simple combination
of what we already have readily available; otherwise, it
cannot add value. A candidate strategy may add value
only if we expect it to yield a materially positive alpha
relative to other strategies already available to us. Our
expectation may be based either on historical or sub-
jective estimates, a theme that we explore further in
our case study. A positive expected alpha is not itself
sufficient to justify investment in an advanced beta;
the alpha must also be attractive relative to its residual
risk and within an overall active risk budget. This is
analogous to a traditional active manager having a con-
vincing expected information ratio after controlling for
its effective portfolio mix. Second, an investor who is
considering new smart beta strategies most likely already
has a firm belief in the advantages of the elementary
smart betas, including an understanding of the range of
expected premiums and volatility of ESBs. Therefore,
the choice of a small set of investible elementary smart
beta factors provides a logical foundation for portfolio
construction.
Setting assumptions involves first establishing
expected return and covariance estimates for the ESBs.
For candidate strategies, we also need to estimate factor
weights and residual risk and return. The latter involves
subjective estimates akin to evaluating an equity manag-
er’s expected alpha—not an easy task. The factor model
based on ESBs provides a structure for understanding
how combinations of smart beta and multifactor strate-
gies accumulate in the portfolio and what changes in
portfolio weights might improve overall performance.
Later, in the case study section of this article, a fully
worked example will show some reasonable assump-
tions that are established as guidance. Of course, we
may be wrong about our factor weights (model uncer-
tainty), and we may be wrong about our estimates of
the residual returns (parameter uncertainty); neverthe-
less, this ESB factor model helps reduce ambiguity in
candidate strategies and can lead to potentially more
robust conclusions.7
BLENDING ADVANCED BETAS
The objective of investing in smart betas, multi-
factor strategies, and other advanced betas is to improve
overall portfolio performance in terms of expected
return and risk. The Technical Appendix provides a
Quantitative Special Issue 2018
framework for optimizing expected utility of returns
1
U = r − λσ 2 that produces mean–variance-efficient
2
allocations to advanced betas in the total portfolio con-
text. Here, we simplify the narrative by considering a
single asset class (e.g., global equity) with investments
in several ESBs but with only a single advanced beta.
We also simplify by assuming that elementary smart
betas are uncorrelated, assuming advanced beta residuals
are uncorrelated with ESBs, and ignoring budget con-
straints. The total return of the portfolio is
r = {hb rb }policy + {∑ h i
r
esb ,i esb ,i } smart beta
{
+ hab ( f b rb + ∑ i f esb ,i resb ,i + α ab ) }
adv . beta
(2)
The total return is composed of the benchmark
return (the first component), the direct exposure to
the elementary smart betas (the second component),
and additional exposures associated with advanced beta
(the next three components derived from the factor
model in Equation (1)). Allocations to advanced beta
modify exposure to the asset class (if strategies are
leveraged or deleveraged), add incidental exposure to
the ESBs, and add exposure to advanced beta residuals.
The expected return and variance, with rearrange-
ment, are
r = (hb + hab f b )rb
+ ∑ i (hesb ,i + hab f esb ,i )resb ,i + hab α ab (3)
σ 2 = (hb + hab f b )2 σ b2
+ ∑ i (hesb,i + hab f esb,i )2 σ esb
2
,i + hab ω ab
2 2
(4)
where aab and ω ab2 are the residual return and variance
of advanced beta. This is a simplified version of the
vector and matrix relationships (Equations (A-1) and
(A-2)) for expected return and variance in the Technical
Appendix.
Optimal Allocations: Total Return
We assume that investment policy is fixed but that
our holdings of ESBs and advanced beta are uncon-
strained. The optimal (mean–variance-efficient) holdings
then are determined by the first-order conditions
The Journal of Portfolio M anagement    95
 ∗ 1 resb,i
hesb,i = − f esb ,i hab∗ i = 1, …, nesb (5)
λ σ esb
2
,i
1 ship for optimal holding of advanced beta. The optimal
hab∗ = [ f b2 σ b2 + ω ab2 ]−1[ ( f b rb + α ab ) − f b σ b2 hb ] (6)
λ ratio of expected return and risk associated with leverage
These results are analogous to the conditions in
Equations (A-7) and (A-8) in the Technical Appendix.
The big picture is that optimal allocation to elementary
smart betas is driven by the return/variance ratio of the
ESBs (the first term of Equation (5)), with an adjustment
for the incidental exposure to ESBs caused by optimal
holdings of advanced beta (the second term of Equa-
tion (5)). Similarly, the optimal allocation to advanced
beta is driven by the return/variance ratio associated
with the advanced beta residual and the market index
exposure caused by advanced beta (the first term of
Equation (6)). There is also an adjustment to account
for the risk associated with leverage/deleverage effects
on investment policy. Notably, the underlying style of
the advanced beta in terms of elementary smart betas
as determined in Equation (1) is irrelevant because any
exposure to ESBs is fully adjusted in Equation (5) to
attain optimal exposure to ESBs. In effect, we choose
the optimal allocation to advanced betas, and then the
ESB allocations provide a completion portfolio to ensure
that the overall allocation to ESBs is also optimal.8
Optimal Allocations: Active Return
The preceding discussion centered on the problem
of asset allocation in the total return space. A related
problem is optimizing the expected utility of active
1 budget than Portfolio 5; in practice, it is common to
returns to maximize UA = rA − λσ 2A. In this problem,
2
we are concerned with the active return (in excess of the
policy benchmark) and the active risk (tracking error rel-
ative to policy benchmark). Starting with Equation (2),
we remove the policy component and proceed to deter-
mine first-order conditions for optimal allocations with
this new objective. The unconstrained optimal holdings
for the active problem are
∗ 1 resb,i
hesb,i = − f esb ,i hab∗ i = 1, …, nesb (7)
λ σ esb
2
,i
1 expected return than Portfolio 5 but with a decreasing
hab∗ = [ f b2/ab σ b2 + ω ab2 ]−1 ( f b/ab rb + α ab ) (8)
λ
96    Optimal Blending of Smart Beta and Multifactor Portfolios Quantitative Special Issue 2018
The result of Equation (7) is the same relation-
ship as in Equation (5) for optimal holdings of ESBs,
and the result of Equation (8) is a simplified relation-
holdings of advanced beta are again proportional to the
and residual risk from advanced beta, but the term for
the leverage/deleverage impact on investment policy
is absent. This result of Equation (8) is analogous to
Equation (A-10) in the Technical Appendix.
By varying an investor’s risk preferences (l), we
can generate a range of efficient portfolios and compare
various portfolios to this efficient set. Exhibit 1 demon-
strates an example of the relationships and distinctions
between portfolios of advanced betas and ESBs in the
active efficient frontier space that includes the require-
ment that holdings be long only and a total holdings
constraint. In this example, Portfolio 0, with no allo-
cations to ESBs or advanced betas, is an index fund
with no active return and risk. Portfolio 5 achieves the
greatest possible expected active return given an active
risk budget of 3%. The final portfolio can be thought of
as the sum of Portfolio 1, the best achievable advanced
beta exposures; Portfolio 3, the incidental delever-
aging associated with those exposures; and Portfolio 4,
the best portfolio of ESBs, adjusting for the incidental
exposure in Portfolio 3. Portfolio 2 is the incidental
ESB exposure from the allocation to advanced betas;
the difference between Portfolio 4 (best ESBs) and
Portfolio 2 (incidental ESBs) indicates the improvement
in Portfolio 5 resulting from the completion portfolio.
Depending on the investor’s risk preferences (l),
the investor may choose a higher or lower active risk
set an active risk budget for each asset class. If a lower
risk budget is chosen, then the optimal Portfolio is a
combination of Portfolio 0 and Portfolio 5 and falls on
the straight line between the two portfolios. These port-
folios include an allocation to index funds along with a
proportionate reduction in the allocation to the optimal
blend of ESBs and advanced betas, and they dominate
Portfolios 1–4. If a higher risk budget is desired, then
the optimal Portfolio lies on the active efficient fron-
tier to the right of Portfolio 5, where the holdings and
long-only constraint are binding. Portfolios to the right
of Portfolio 5, with no index allocations, have higher
information ratio as active risk increases.
Exhibit 1
Active Efficient Frontier of Advanced Beta and Other Portfolios
Impact of Leveraged or Deleveraged
Advanced Beta
Advanced betas, and many well-known smart
betas, as described in Equation (1), are frequently found
to have factor weights with respect to the underlying
market index. For example, low-volatility smart betas—
and advanced betas built upon them—typically have a
large negative factor weight with respect to the equity
index ( f b < 0), and this may reduce the desirability of
the associated advanced beta. Allocations to smart betas
with this feature consume a large amount of active
risk budget; in the total portfolio context, they effec-
tively change the exposures set by investment policy.
If this exposure is well understood, then the impact
can be reversed fairly cheaply via derivatives, by com-
pensating adjustments to the strategic asset allocation
or by demanding strategies without leverage. A further
Quantitative Special Issue 2018
benefit of neutralizing the leverage issue is that, in this
case, the general problem of optimizing the alloca-
tions to active betas in the total portfolio context can
be simplified to the active-only case, as demonstrated
in the Technical Appendix. In our case study, we will
investigate the impact of leverage adjustment on total
portfolio performance further.
CASE STUDY
An example will help demonstrate the principles
and practicality of blending advanced betas and smart
betas. We consider an institutional investor that is seeking
to improve investment performance of the total port-
folio via advanced beta, having already established an
investment policy of 70% equities and 30% bonds (other
asset classes are ignored for simplicity). We will set out
the assumptions and then show the optimal holdings of
The Journal of Portfolio M anagement    97
Exhibit 2
Returns and Risks of Beta and Elementary Smart Beta Factors, Annual Estimates Based
on Monthly Returns (1997–2015)
advanced beta within the equities portfolio as described
in the prior section, but relying on the more complete
framework from the Technical Appendix.
Assumptions
We need to establish assumptions about asset class,
elementary smart beta, and advanced beta expected
returns and covariance. Exhibit 2 shows the histor-
ical return and risk for asset classes and ESBs and the
assumed forward-looking estimates.9 The forecasted risk
is rounded from the historical data, and the forecasted
return is based upon an assumed forward-looking Sharpe
ratio. The Sharpe ratios for the ESBs are assumed to be
equal across smart betas but lower than the asset class
ratios. The estimates are intended to be conservative;
they are lower than historical experience, except in the
case of the value premium, which performed unusually
poorly in the backtest period compared with its long-
term average. Exhibit 3 shows the historical estimates for
correlations. Except for the correlation between value
and momentum, no estimates were statistically signifi-
cant during the period. Our forward-looking assump-
tions are that the value–momentum correlation is -0.5,
and the correlation between bonds and equities is +0.2.
Other correlations between ESBs are set to +0.2 to pro-
vide conservatively higher portfolio risk estimates.
The assumptions for advanced beta strategies are
based on fitting the factor model in Equation (1) plus
the analyst’s judgment. We study four hypothetical
candidate advanced beta strategies, characterized in
Exhibit 4. The factor weights in these samples have
been chosen to be broadly representative of some types
of commercially available strategies, based on our own
returns-based style analysis and judgment, and ref lecting
what we should know from our due diligence on each
98    Optimal Blending of Smart Beta and Multifactor Portfolios Quantitative Special Issue 2018
Exhibit 3
Correlation between Asset Class and Smart Beta
Factors, Monthly Returns (1997–2015)
multifactor strategy. For example, the first candidate
is a variation on a value strategy, with larger small-cap
exposure than found in the MSCI ACWI Value Index;
the second represents a more extreme small-cap tilt and
tries to capture factor exposures not included in our set
of elementary smart beta (such as quality); the third is a
more straightforward quality approach; and the fourth
is a representation of a low-volatility approach.
We assume reasonable idiosyncratic risk based on
our examples, that the residuals are uncorrelated, and an
equal information ratio for each advanced beta strategy.
We therefore obtain a forward-looking estimate of
expected residual return by multiplying the information
ratio by the residual risk. Nothing in the methodology
prevents us from making other assumptions, based on
our study of candidate strategies. For example, an analyst
could choose to assume different information ratios based
on knowledge of the advanced beta strategy or manager.
Optimal Holdings and Performance
We shall assume that an active risk budget of 3.0%
at the asset class level is set for the exposures associated
with allocations to smart beta and advanced beta.
Exhibit 4
Forward-Looking Assumptions for Advanced Beta Candidates
Exhibit 5 shows the holdings and performance for the
optimal (mean–variance-efficient) portfolios that were
determined from a standard optimizer. Using only
elementary smart betas (column 1), the portfolio has
an expected active return of 1.4%. The portfolio allo-
cates most heavily to value and then momentum
and least heavily to small. To understand why this
allocation makes sense, recall that we assume equal
expected information ratios across the smart betas, so
the allocations are driven primarily by risk. Value and
momentum are negatively correlated, so allocating
more to this pair of smart betas has a strong diversifi-
cation benefit. In balancing between these two, value
is given a higher allocation because it has less risk than
momentum. Small also has a place in the portfolio, as
it is uncorrelated with value and momentum, and it
has an intermediate level of risk. Because of diversifi-
cation benefits, the smart beta–only portfolio attains
an expected information ratio of 0.48, whereas the
component smart betas have standalone information
ratios of only 0.25.
The portfolio with advanced beta only (column 2,
with no direct allocation to ESBs) makes allocations to
all four strategies. The allocation across advanced betas
is driven by the attractiveness of the residual return and
risk, but also by the effective asset mixes, including
(in advanced betas 3 and 4) some deleveraging. In our
framework, deleveraging consumes some of the active
risk budget but also reduces risk in the total portfolio.
The performance of the advanced-beta-only portfolio is
slightly higher (expected active return of 1.5% compared
with 1.4%) than the smart-beta-only portfolio based on
our choices of advanced betas and incidental ESBs but
without allowing for direct adjustments in ESBs.
Exhibit 5 also presents the results for combina-
tions of both smart beta and advanced beta. The result
indicated by “without leverage adjustment” (column
Quantitative Special Issue 2018
3) refers to the case in which the cumulative leverage/
deleverage implicit in advanced betas is permissible in
the total portfolio. In this case, the holdings of advanced
betas effectively move the total portfolio asset alloca-
tion away from investment policy, and this presents a
governance issue for the chief investment officer. The
result indicated by “with leverage adjustment” (column
4) refers to the case in which the leverage/deleverage
implicit in advanced betas is corrected to ensure that
the total portfolio asset allocation is congruent with
investment policy. This leverage adjustment may be
accomplished in different ways—by the investor via
derivatives or readjustment of the asset allocation to pre-
cisely compensate, or by requiring the investment man-
ager to deliver a product that is on benchmark without
any need for adjustment. Allowing for both advanced
betas and direct investment in smart betas, the expected
active return improves appreciably to 1.8% (without
leverage adjustment) or 2.1% (with leverage adjust-
ment). The expected active return/risk ratio is 0.61
(without leverage adjustment) or 0.68 (with leverage
adjustment), compared with 0.51 for the smart-beta-
only portfolio and 0.48 for the advanced-beta-only
portfolio. In the case of leverage adjustment (B), the
allocations to advanced betas 3 and 4 are increased
compared with the case without leverage adjustment
(A) because the penalty associated with deleverage is
neutralized. In either case, by blending in the advanced
beta, we gain additional return and diversification ben-
efits across the advanced beta residual returns, and we
are able to adjust the allocation to ESBs via a comple-
tion portfolio. The allocations to advanced betas add
significant incidental exposures to value and size but not
to momentum; therefore, a larger, direct allocation to
momentum is desirable as part of a completion portfolio.
Considering both the direct and indirect allocations to
smart beta, the portfolio with advanced beta implies net
The Journal of Portfolio M anagement    99
Exhibit 5
Optimal Portfolios
allocations to smart betas that move toward the optimal
ESB allocations.10
Impact on Total Portfolio
Exhibit 5 also shows the total return and total
risk of the three portfolios, when combined with the
policy portfolio, based on an active risk budget of 3%
within the equity portfolio. It is possible to increase or
decrease the active risk budget, as discussed in the pre-
vious section. The investor’s decision should be based
on a trade-off between what is needed to attain desired
outcomes (total return and risk) and the investor’s con-
fidence in his or her own skill in selecting strategies that
may outperform.
Exhibit 6 displays the range of mean–variance-
efficient portfolios that are possible for the investor at
various active risk budgets. On top of an ordinary effi-
cient frontier for traditional asset classes, we have placed
an active tail derived from the active efficient frontier
introduced in the previous section. The base on the tail
represents an investment policy with a 70–30 stock–
bond allocation that is fully indexed (no smart beta or
advanced beta). Points along the active tail represent
optimal portfolios for various active risk budgets between
100    Optimal Blending of Smart Beta and Multifactor Portfolios Quantitative Special Issue 2018
0% and 3% within the equity asset class. As we increase
the active risk level, the expected return increases along
the tail because of positive incremental returns from
smart beta and advanced beta. Portfolios A (without
leverage adjustment) and B (with leverage adjustment)
are the optimal advanced beta and smart beta portfolios
referred to in Exhibit 5.
A notable feature of the advanced beta tail without
leverage adjustment is that it bends leftward at first,
showing that the inclusion of advanced beta reduces total
risk in this example. Risk reduction is caused by the
allocation to advanced betas 3 and 4. Because of the dele-
veraging implicit in these strategies, we are effectively
reducing the overall portfolio allocation to equities. With
leverage adjustment, the total risk always increases as we
increase the active risk budget. Nevertheless, all portfo-
lios on the efficient frontiers with leverage adjustment
(Active Tail B) have a higher total return at any given
active risk budget than portfolios without leverage
adjustment (Active Tail A). For example, Portfolio B
(with leverage adjustment) has higher expected return
than Portfolio A (without leverage adjustment), although
both portfolios have the same active risk of 3.0%. Under
our assumptions, there is an active risk budget constraint
that effectively penalizes advanced beta strategies that
Exhibit 6
Efficient Frontier and Active Tail for Advanced Beta and Optimal Portfolios with 3% Active Risk
deleverage the market return. As deleverage consumes
the active risk budget while producing negative expected
returns, Active Tail B is always preferred to Active Tail A.
Ignoring the active budget constraint for the moment,
we are able to attain the same return from Active Tail A
with lower total risk than from Active Tail B; however,
this is not a fair comparison because our active budget
constraint implies that both active risk and total risk
matter to the investor. Another perspective is that users
of smart or advanced beta must think carefully about the
market exposures generated by those strategies; other-
wise, some strategies may have the unintended effect of
changing investment policy indirectly.
This case study has demonstrated that it is practical
to optimize exposures to advanced betas and smart betas
in a total return context and that the resulting portfolios
may have material benefits for investors based on our
assumptions. If the reader is unconvinced by this, con-
sider that the same methodology—with less favorable
assumptions about advanced beta and smart beta—could
be used to prove just the opposite.
Quantitative Special Issue 2018
CONCLUSION
This article has presented a methodology for
optimal allocation to smart beta and multifactor strate-
gies (advanced betas) from an investor standpoint, based
on standard principles of portfolio construction and set-
ting explicit forward-looking return expectations that
are familiar from other portfolio contexts. This contrasts
with much of the current discussion of portfolios of
smart betas based on historical returns and mechanical
risk-budgeting strategies. A key innovation is to begin
with a simple factor model for each advanced beta that
includes exposure to investment policy factors, a lim-
ited set of elementary smart betas, and a residual return
unique to the strategy.
Two principal findings about optimal blending
emerge. First, allocations to elementary smart betas
depend principally on the ratio of expected excess return
to expected variance, adjusted to account for implicit
holdings of similar factors elsewhere in the portfolio.
Second, allocations to multifactor advanced betas should
The Journal of Portfolio M anagement    101
proceed similarly, with an adjustment for leverage/ where
deleverage but without the need to adjust for any
rab is the n ab  × 1 vector of excess returns of
embedded holdings of elementary smart beta. Beyond
advanced beta
guidance on the best allocations across smart beta and
multifactor strategies, this process also informs us about  r  is the (nb + nesb ) × 1 vector of returns of asset
rbsb =  b 
the characteristics of advanced beta strategies that would  resb  classes and ESB factors
be most beneficial for investor outcomes.
For investors concerned about active performance rabr is the n ab × 1 vector of residual returns for
advanced beta
relative to investment policy benchmarks, strategies that
embed significant deleveraging relative to the market F = [ Fb Fesb ] is the n ab  × (n b  + n esb ) matrix of estimates
(i.e., have a beta to the market substantially different defining the effective mix of market and ESB
factors associated with advanced beta.
from one), such as low-volatility strategies, should be
approached with caution. Our framework brings into
question the common practice of treating low volatility Expected Return and Risk of Total Portfolio
as another anomaly similar in principle to the other Based on vectors of investment policy holdings hb ,
well-known anomalies. Not only does the low-vola- direct investment in elementary smart beta hesb, and advanced
tility anomaly typically contribute higher active risk beta hab, the effective total holdings of beta and smart beta are
than the other anomalies, but its deleveraging exposure hbt = hb + Fb′ hab and hesbt = hesb +Fesb′ hab. We then have the expected
also detracts from expected returns (arguably by less return and variance of the total portfolio:
than the capital asset pricing model prediction). Thus,
any anomaly that embeds significant deleveraging seems r = ht′r
more fit for exploitation by investors focused specifi-  r 
cally on achieving lower total risk in their portfolios (by  b  (A-1)
= [ hbt′ hesbt
′ hab′ ]  resb 
effectively deviating from investment policy) rather than  
providing an active return contribution.  rabr 

Finally, there is currently a lively debate on whether
factor strategies are best implemented through a series of σ 2 = ht′Vht
single-factor portfolios or through a single, engineered,  V 0 0  h 
multifactor portfolio. The present framework identifies  b   bt  (A-2)
= [ hbt′ hesbt
′ hab′ ]  0 Vesb 0   hesbt 
the complex portfolio trade-offs and detailed assump-   
tions across factors that would be required to make that  0 0 Vabr   hab 

assessment, but it does not provide a final answer to the where
question. Nevertheless, we believe that the methodology
can provide a useful basis for answering these questions r is the (nb + nesb + n ab ) × 1 vector of expected returns
and improving advanced beta implementation for both for beta, smart beta, and advanced beta residuals
asset managers and asset owners. Vb is the n ac × n ac matrix of covariance of standard asset
classes
Vesb is the nesb × nesb matrix of covariance of elementary
Te c h n i c a l A p p e n d i x smart beta factors
Vabr is the n ab × n ab matrix of covariance of advanced beta
Style Analysis of Advanced Beta
residuals
The normal portfolio for advanced beta strategies is A diagonal block structure of V is suggested here to
estimated in terms of investment policy benchmark returns, simplify the expansions in the next section and to aid inter-
elementary smart beta factors, and residual returns: pretation of the optimization results. This assumption has
been reasonably supported in case studies by observing very
rab = Fb rb + Fesb rsb + Irabr , low cross-correlation between elementary smart beta and
advanced beta exposures within asset class exposures.

102    Optimal Blending of Smart Beta and Multifactor Portfolios Quantitative Special Issue 2018
 Objective Function
The investor seeks a portfolio that maximizes the
expected utility of total return and total risk. We take the
1 1
investor’s objective function to be U = r − λσ 2.11 It is helpful
2 2
to parse the objective function into components associated
with policy, smart beta, and advanced beta. Expected total
return and risk is then expanded from Equations (A-1) and
(A-2) to
r = {hb′ rb }policy + {hesb
′ resb }smart beta
+ {hab′ [ Fb rb + Fesb resb + rabr ]}adv beta (A-3)
σ 2 = {hb′Vb hb }policy + {hesb
′ Vesb hesb }smart beta
+ {2hb′Vb Fb′hab + 2hesb
′ Vesb Fesb′ hab }cross terms
+ {hab′ FV
b b Fb′hab + hab
′ FesbVesb Fesb′ hab + hab′ Vabr hab }adv beta
(A-4)
Optimization
We consider investment policy to be fixed. The first-
order conditions for the unconstrained optimization are
resb − λ[Vesb hesb + Vesb Fesb′ hab ] = 0 (A-5)
Fb rb + Fesb resb + rabr − λ[ FV
b b hb + FesbVesb hesb
+ (FV ′ + Vabr ) hab ] = 0 (A-6)
b b Fb′+ FesbVesb Fesb
The optimal holdings are then
∗ 1 −1
hesb = Vesb resb − Fesb′ hab∗ (A-7)
λ advantages of a bottom-up approach in multifactor portfo-
−1  1  lios. However, Amenc et al. [2017] suggested that although
hab∗ = [ FV
b b Fb′+ Vabr ]  ( Fb rb + rabr ) − FV
b b hb 
λ 
Equation (A-7) shows that the optimal holdings of ESBs
are directly proportional to expected returns and inversely
proportional to the contribution of ESBs to risk, adjusted for
the ESB exposure present in our optimal holdings of advanced
betas. The second set of conditions shows a similar direct rela-
tionship to returns and inverse relationship to contribution
to variance. In this case, the returns include both the residual
returns and the implied leveraged or deleveraged market
return, and the contribution to variance is similarly adjusted.
Holdings do not depend on ESB factors associated with
advanced beta. There is also an adjustment term associated
Quantitative Special Issue 2018
with leveraging caused by advanced beta. This latter term
demonstrates that optimal allocations to advanced beta and
smart beta depend on investment policy if Fb ≠ 0.
In the case of active return optimization, our objective
is U A = rA − λσ 2A, and we modify Equations (A-3) and (A-4)
by subtracting the investment policy term. The optimal active
holdings are then
1 −1
∗
hesb = Vesb resb − Fesb′ hab∗ (A-9)
λ
−1  1  (A-10)
hab∗ = [ FV
b b Fb′+ Vabr ]  ( Fb rb + rabr ) 
λ 
Conditions in Equation (A-9) for optimal holdings of
ESBs are the same as Equation (A-7) in the total return case,
except for any changes in hab∗ . Conditions in Equation (A-10)
for the optimal holdings of advanced betas are simplified and
do not include the leverage penalty term in Equation (A-8).
Thus, if we have no leverage associated with advanced beta
(Fb = 0), the total return problem and the active-only problem
result in equivalent allocations under our assumptions.
ENDNOTES
1
Dimson, Marsh, and Staunton [2017] reported that
the proportion of large-asset owners using at least five smart
beta indexes has risen 10-fold, from 2% in 2014 to over 20%
in 2016. Morningstar [2016] reported that, as of mid-2016,
there were 1,123 exchange-traded products involving smart
beta, with collective assets under management of approxi-
mately $550.5 billion worldwide. This does not include
many smart beta assets in other formats. See also Kahn and
Lemmon [2016].
2
Bender and Wang [2016] demonstrated the efficiency
lios compared with a combination of single-factor portfo-
(A-8) factor score intensity improves, ref lecting that improvement
in higher performance of multifactor portfolios is more
challenging.
3
See Sharpe [1988, 1992] for a description of returns-
based style analysis, which is similar to a regression of monthly
returns that is constrained to ref lect a fully invested, long-
only benchmark.
4
The Fama–French versions of the factors are not
readily investible and, therefore, are not a relevant benchmark
for comparison with other smart beta funds. Technically, the
MSCI indexes are not investible either. We take the indexes,
however, as reasonable proxies for relatively low-cost, low-
tracking-error investible replications of the factors.
The Journal of Portfolio M anagement    103
 5
Based on monthly returns from 1997 to 2015, small
and value SB have a correlation of +0.016; momentum
and small SB have a correlation of +0.081; and value and
momentum SB have a correlation of -0.497. The negative
correlation between value and momentum factors has been
well established, both within and across asset classes. Dimson,
Marsh, and Staunton [2017] showed long-term evidence for
risk premiums associated with these three smart betas. See
also Fama and French [1992]; Carhart [1997]; and Asness,
Moskowitz, and Pedersen [2013]. The three ESB factors are
also uncorrelated with the ACWI and GBMI indexes used to
represent stock and bond asset classes in this article.
6 REFERENCES
Remembering that quality is negatively correlated
with value and small, it is not surprising that a best-fit model
(based on ACWI index data from 1999 to 2015) of a quality
smart beta yields an unconstrained factor portfolio that would
be significantly short on value and small ESBs and have a
negative alpha. Constraining it to a long-only portfolio, we
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As Kim, Kim, and Fabozzi [2017] pointed out,
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1 rb
8
Note that if λ coincides with optimal policy, hb =
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See J.P. Morgan [2015] for a comprehensive report
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10
The effective allocation to elementary smart beta
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104    Optimal Blending of Smart Beta and Multifactor Portfolios Quantitative Special Issue 2018
ESB-only optimal allocations are value 55% versus 51%, small
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11
The discussion of objective functions follows the
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