The Smart Beta 2.0 approach

By Noël Amenc – Interest in new forms of indexation, referred to as smart beta strategies, has grown in recent years. Investors are attracted by the performance of these indices compared to traditional cap-weighted indices. However, by departing from cap-weighting, smart beta equity indices introduce new risk factors for investors, and sufficient attention is not presently given to the evaluation of these risks. In addition, the smart beta market appears to be inefficient today, due to restricted access to information, as well as lack of independent analysis.

EDHEC-Risk Institute recently put forth a new approach to smart beta investment, called the “Smart Beta 2.0” approach*.

A first important step towards a better understanding of smart beta strategies is to conduct proper analysis of risk and performance of smart beta strategies rather than relying on demonstrations of outperformance typically conducted by the providers of the strategies.

Secondly, Smart Beta 2.0 allows investors not only to assess, but also to control the risk of their investment in smart beta equity indices. Rather than only proposing pre-packaged choices of alternative equity betas, the Smart Beta 2.0 approach allows investors to explore different smart beta index construction methods in order to construct a benchmark that corresponds to their own choice of risks.

In particular, we address the following types of risk: i) exposure to systematic risk factors (which can be managed through stock selection decisions or factor constraints); ii) exposure to strategy-specific risk (which can be managed by diversifying across strategies); and iii) relative performance risk with respect to traditional market cap-weighted benchmarks (which can be managed through tracking error control).

The choice of systematic risk factors for smart beta benchmarks should 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. 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.

Our “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. We 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, we propose 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.

More than ever, full transparency is required in both the methodology and in the composition of indices. More information is indispensable in the creation of an efficient market for smart beta indices and will help investors to make clear choices, notably in terms of risks, when choosing and customising their new benchmarks.

*Amenc, N., F. Goltz, L. Martellini, April 2013, “Smart Beta 2.0,” EDHEC-Risk Institute Position Paper

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