18 March 2013

EDHEC: Smart Beta 2.0 – Taking the risks of new equity benchmarks into account

EDHEC-Risk Institute is seeking to draw the attention of investors to the risks of traditional smart beta equity indices, and proposes a new approach to smart beta investing to take account of these risks.

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.

Press release

Full paper

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