Edhec-Risk warns of hazards of Smart Beta indices

The EDHEC-Risk Institute has warned that aspects of traditional smart beta equity indices are inadequate and proposes a new approach which enables better measurement and control of the risks.

The new approach, called “Smart Beta 2.0” revolutionises the offerings of advanced equity benchmarks, according to authors Noël Amenc, Felix Goltz and Lionel Martellini.

They charge that established Smart Beta “1.0” indices present systematic and specific risks that are neither documented nor explicitly controlled by their promoters.

Inadequate information and 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, they explain.

EDHEC-Risk recommends the choice of systematic risk factors for smart beta benchmarks be explicit, and made by the investor, not 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.

So it is 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 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 is often characterised as model and parameter estimation risk can be measured and 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.

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.

The researchers call for full transparency both in methods and in the composition of indices. More information is indispensable in the creation of an efficient market for smart beta indices that help investors to make clear choices.

A copy of the study is available by clicking on the following link:

EDHEC-Risk Institute Position Paper Smart Beta 2.0

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