Written on 21 October 2014.
Starting with the observation that if the performance of smart beta comes from efficient allocation to smart factor indices maximising the risk-adjusted performance for a given factor exposure, EDHEC’s researchers show that the implementation of a risk allocation solution to support this efficient allocation to smart beta enables the risk constraints to be respected in both absolute and relative terms.
Two major results can be highlighted:
• In relative terms, it is possible to sharply reduce the tracking error and the relative drawdown of the smart beta investment with robust risk allocation techniques in a portfolio of smart beta indices. As such, a Relative Equal Risk Contribution (ERC) or Relative Global Minimum Variance (GMV) approach for a Developed World universe gives tracking error of around 2.5% with relative drawdown of 5%.
• In absolute terms and as part of a long-only allocation, even though investable smart beta indices are never pure in the long-only space, it is possible to respect factor risk parity constraints. This result means that it is not necessary to turn to long/short or highly concentrated factor indices that present investability problems and are particularly poorly diversified when reaching objectives on controlled exposure to risk factors.
Commenting on this research, Noël Amenc, Director of EDHEC-Risk Institute and CEO of ERI Scientific Beta, said, “For EDHEC-Risk Institute, the challenge with smart beta investing today is not only to avail of smart factor indices with good risk-adjusted performance but also to allocate to these smart factor indices in a risk-efficient way. This new publication shows how this can be done.”
Valérie Baudson, Global Head of ETF & Indexing at Amundi, comments: “Institutional investors are showing growing interest in, and increasingly using, smart beta, which is definitely a strategic axis of development for Amundi. We are delighted to support EDHEC- Risk Institute, which, with this new research paper, provides additional guidance for investors to optimize the implementation of smart beta strategies in their asset allocation.”
A copy of “Risk Allocation, Factor Investing and Smart Beta: Reconciling Innovations in Equity Portfolio Construction” can be downloaded via the following link:
This research was supported by Amundi ETF & Indexing as part of the research chair at EDHEC-Risk Institute on “ETF and Passive Investment Strategies.”