A New Metric for Smart Beta: Factor Exposure per Unit of Tracking Error

Abstract

What does success look like for smart beta indexes? The authors argue that success is the ability of an index to provide a strong and consistent level of exposure to the targeted factor(s). Moreover, exposure should be achieved in a risk-aware way. Risk taken relative to the capitalization-weighted benchmark is active risk, and investors should be compensated with greater exposure to their targeted factor(s). The authors provide guidance on how indexes can be built with this measure in mind via screening and weighting decisions. Because screening and weighting decisions move tracking error and exposure in the same direction, most rules-based indexes naturally provide reasonably strong exposure per unit of tracking error.