Written on 04 November 2014.
Professor Lionel Martellini, Scientific Director of EDHEC-Risk Institute and Senior Scientific Advisor ERI Scientific Beta gave a conference on Smart Beta to EDHEC Financial Economics students in Nice on November 3rd.
Your conference was on Smart Beta investing. Could you tell us a bit more what this concept is all about?
In the last 5 to 10 years, a number of index providers and asset managers have launched so-called smart beta equity indices and portfolios with a focus on addressing the main shortcomings of cap-weighted indices, namely their excessive concentration that leads to an excessive presence of unrewarded risk, as well as their inefficient factor exposures.
What are the the different forms of Smart Betas?
Smart beta indices include various approaches that are based either on scientific diversification (e.g., indices aiming at implementing a minimum variance or max Sharpe ratio allocation to selected stocks subject to a number of constraints either on weights or on parameter estimates that are meant to improve the robustness of the portfolio construction methodology) or naïve diversification (equal-dollar contribution or equal risk contribution indices).
Are there any risks associated with smart equity and if yes, what are they?
As with any technique or any model, implementation of these new forms of benchmarks is not risk-free. In order to justify why cap-weighted indices are no longer considered as good benchmarks, smart beta promoters raise their risks of concentration, and rightly so, but it is also necessary to grasp the risks to which investors are exposed when they adopt alternative benchmarks. Talking about the superiority of smart beta indices over the long term is totally legitimate, but it is also perfectly legitimate to discuss the sources of this outperformance, the risks of the outperformance not being robust, or even the conditions of underperformance in the short or medium term.
One key problem with these smart beta portfolios (at least with the first generation of such portfolios), a problem which they share with cap-weighted portfolios, is that they do not allow for any explicit control of rewarded risk exposures. Hence, by switching from a cap-weighted index to an equally-weighted or global minimum variance index for example, the investor is switching from one arbitrary bundle of factor exposures to another arbitrary bundle of factor exposures, which may or may not be consistent with the investor's needs and beliefs.
What is the involvement of EDHEC-Risk Institute in this domain?
EDHEC-Risk Institute has become one of the most prominent providers of academic research on the subject of smart betas. Our research has allowed investors to better be able to understand the shortcomings of existing equity benchmarks, understand and compare the various forms of smart beta benchmarks, understand the systematic and specific risks involved with smart betas, understand how to bundle together various forms of smart betas, and finally understand how to use smart betas as building blocks for efficient investment solutions. We have lately moved from research to production with the launch of the first smart beta platform, which allows investors and asset managers to gain access to almost 3 000 different smart beta indices, and analyse the risk and return characteristics (see www.scientificbeta.com for more details).
What role can EDHEC students expect to play in this burgeoning field?
The growing interest in the industry for smart beta investing suggests an increasing set of exciting job opportunities for young graduates with the proper training, and our students are ideally equipped to seize such opportunities.
More information on Smart Beta here.