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.
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.
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.
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.