Focus on smart beta – investors apply smart beta approach to bonds

Smart beta solutions were originally developed for equities, but now some of the key product providers such as Lyxor Asset Management are offering the same approach for bonds.

Over the past few years since the onset of the 2008 financial crisis, equities have been considered the riskiest asset class and investors have been on the search for solutions to hedge against these risks and diversify their equities portfolios.

This is where smart beta solutions come in. They allow an investor to allocate to an equity index in a “smart way” by controlling the risk exposure of a portfolio. To achieve this, the smart beta portfolio weighs stocks based on their risk contribution rather than market weighting.

Lyxor Asset Management has developed the Equal Risk Contribution (ERC) strategy, which weights the risk contribution of each component of an index equally. The strategy seeks to minimize the investment biases inherent to market cap indexing, among which its tendency to concentrate risks into a limited number of components.

In a volatile environment, this approach can help protect the portfolio on the downside and capture some of the upside of the equity market. The passive approach allows an investor to keep down the costs, which is an advantage over actively managed funds (which charge management fees).

Guillaume Lasserre, head of custom solutions at Lyxor Asset Management, says institutional investors have been using smart beta indices to diversify their equity portfolio holdings in a passive way. It is less about the outperformance and more about diversification and hedging, he says.

Now, the same investors are asking for similar solutions for bonds. This interest stems from the changing risk profiles of asset classes. Bonds, which have been considered a safe haven investment, have lost this status due to the sovereign wealth crisis.

In response to investor demand Lyxor has developed smart beta solutions for bonds together with Citigroup, available on Bloomberg from this year. It is one of only few providers to have moved into this space so far.

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