Factor Investing and Risk Management: Is Smart-Beta Diversification Smart?

In this paper, we investigate the diversification benefits associated with factor investing in U.S. stock markets, using the dummy-variable framework for asset allocation. We find that beta-based investment strategies are primarily driven by beta-specific sources of return variation. At the same time, both betas and characteristics explain the variance of characteristic-based strategies, indicating that beta diversification is a more effective risk management tool than characteristic diversification. We also find that the correlations between the pure premiums of the 14 factor-based strategies considered are small, which suggests that diversification across smart-beta funds is beneficial. Monte Carlo simulations confirm these results.