Written on 18 March 2013.
In research published today entitled, “Smart Beta 2.0,” EDHEC-Risk Institute is seeking to draw the attention of investors to the risks of traditional smart beta equity indices and propose a new approach to smart beta investing to take account of these risks.
This new approach, referred to as “Smart Beta 2.0,” enables investors to measure and control the risks of their benchmark and revolutionises the offerings of advanced equity benchmarks.
In their study, Noël Amenc, Felix Goltz and Lionel Martellini show that Smart Beta 1.0 indices present systematic and specific risks that are neither documented nor explicitly controlled by their promoters.
This inadequate level of information and of risk management calls into question the robustness of the performance presented and implies considerable risk-taking that is not controlled by investors when they choose new equity benchmarks.
In order to deal with this situation, EDHEC-Risk Institute recommends that the choice of systematic risk factors for smart beta benchmarks be clearly explicit. This choice should be made by the investor and not by the index promoter.
The choice, and therefore the associated risk control, is not incompatible with smart beta benchmark performance, as shown by the research results presented in the “Smart Beta 2.0” study. It is thus possible to maintain performance objectives with Smart Beta 2.0 indices without excessively exposing these new benchmarks to size or liquidity risk in comparison with cap-weighted indices.
The “Smart Beta 2.0” study also presents the initial results of the research conducted by EDHEC-Risk Institute in identifying and measuring what is called the “specific” risk of smart beta strategies. This specific risk, which is often characterised as model and parameter estimation risk, can not only be measured, but also managed. The authors show that good diversification of the specific risk of various smart beta weighting schemes significantly lowers the specific risk of smart beta benchmarks.
Finally, in order to deal with a risk of underperforming cap-weighted indices, EDHEC-Risk Institute proposes a method for controlling the extreme tracking error of smart beta indices compared to their cap-weighted equivalents. This tracking error control seems to be a welcome response to the desire of many investors to replace benchmarked asset managers with smart beta strategies in order to outperform market indices over the long term while maintaining a guarantee against excessive short-term underperformance when the market conditions are favourable towards cap-weighted indices.
Concluding on their new Smart Beta 2.0 approach, the EDHEC-Risk Institute researchers reiterate their call for full transparency both in the area of methods and in the composition of indices. More information is indispensable in the creation of an efficient market for smart beta indices that will help investors to make clear choices, notably in terms of risks, when choosing and customising their new benchmarks.
A copy of the study is available by clicking on the following link: