New research details several dangers for smart beta investors
In a new white paper entitled “Misconceptions and Mis-selling in Smart Beta: Improving the Risk Conversation in the Smart Beta Space,” Scientific Beta has warned of the dangers of the main hidden risks that can be important drivers of short-term performance in the smart beta space, namely market risk bias, macroeconomic risks, and sector/geographical risks. Decisions on selecting a smart beta strategy are often driven more by looking at fees and past performance than by analysing risks. As a result, the risk implications of smart beta are not fully understood. In particular, smart beta strategies not only deliver explicit factor exposures (such as value, momentum, etc.) but also lead to implicit exposures.
The white paper, written by Eric Shirbini, Global Research and Investment Solutions Director with Scientific Beta, details these implicit exposures and draws the following lessons:
1. Pay attention to market beta. Market beta drives much of the performance of multi-factor indices, but investors frequently ignore the first-order question of market exposure while focusing on the second-order questions of factor intensity and the best in-sample definitions of factors.
2. Factor strategies are exposed to macroeconomic risks, something investors may not be aware of, as they are not documented by most providers. Macro exposure biases will lead to interaction effects with other factors and other asset classes. For example, strategies with sensitivity to credit risk or interest rate risk will interact with fixed-income portfolios, and a multi-factor portfolio may lack diversification across factors if several risk factors are sensitive to the same macro factor.
3. Managing unrewarded risks is one of the key challenges faced by smart beta investors. Index providers are not always transparent about the implicit unrewarded bets their offerings are exposed to. Sector and region-specific bets are not risks that correspond to priced factors. They therefore have to be documented by smart beta providers and validated by investors.
Commenting on the white paper, Noël Amenc, CEO of ERI Scientific Beta, said, “Although gaining explicit exposure to priced risk factors is expected to provide good long-term risk-adjusted performance, investing in these factors also exposes investors to several non-priced risks that could be important drivers of short-term performance. To reconcile such risk exposures with investors’ preferences, it is crucial that they be well documented. Ultimately, the choice on managing these risks is a key fiduciary decision that cannot be left to the discretion of an index provider that has no status to do so. Asset owners should also start improving governance practices by starting a risk conversation on smart beta investments with stakeholders.”
The white paper can be downloaded from the following link:
Misconceptions and Mis-selling in Smart Beta: Improving the Risk Conversation in the Smart Beta Space
About ERI Scientific Beta
ERI Scientific Beta aims to be the first provider of a smart beta indices platform to help investors understand and invest in advanced beta equity strategies.
Established by EDHEC-Risk Institute, one of the very top academic institutions in the field of fundamental and applied research for the investment industry, ERI Scientific Beta shares the same concern for scientific rigour and veracity, which it applies to all the services that it offers investors and asset managers.
The ERI Scientific Beta offering covers three major services:
• Scientific Beta Indices
Scientific Beta Indices are smart beta indices that aim to be the reference for the investment and analysis of alternative beta strategies. Scientific Beta Indices reflect the state-of-the-art in the construction of different alternative beta strategies and allow for a flexible choice among a wide range of options at each stage of their construction process. This choice enables users of the platform to construct their own benchmark, thus controlling the risks of investing in this new type of beta (Smart Beta 2.0).
Within the framework of Smart Beta 2.0 offerings, ERI Scientific Beta provides access to smart factor indices, which give exposure to risk factors that are well rewarded over the long term while at the same time diversifying away unrewarded specific risks. By combining these smart factor indices, one can design very high performance passive investment solutions.
• Scientific Beta Analytics
Scientific Beta Analytics are detailed analytics and exhaustive information on its smart beta indices to allow investors to evaluate the advanced beta strategies in terms of risk and performance. The analytics capabilities include risk and performance assessments, factor and sector attribution, and relative risk assessment. Scientific Beta Analytics also allow the liquidity, turnover and diversification quality of the indices offered to be analysed. In the same way, analytics provide an evaluation of the probability of out-of-sample outperformance of the various strategies present on the platform.
• Scientific Beta Fully-Customised Benchmarks and Smart Beta Solutions is a service proposed by ERI Scientific Beta, and its partners, in the context of an advisory relationship for the construction and implementation of benchmarks specially designed to meet the specific objectives and constraints of investors and asset managers. This service notably offers the possibility of determining specific combinations of factors, considering optimal combinations of smart beta strategies, defining a stock universe specific to the investor, and taking account of specific risk constraints during the benchmark construction process.
With a concern to provide worldwide client servicing, ERI Scientific Beta is present in Boston, London, Nice, Singapore and Tokyo. As of December 31, 2017, the Scientific Beta indices corresponded to
USD 25bn in assets under replication. ERI Scientific Beta has a dedicated team of 45 people who cover not only client support from Nice, Singapore and Boston, but also the development, production and promotion of its index offering. ERI Scientific Beta signed the United Nations-supported Principles for Responsible Investment (PRI) on September 27, 2016.