The Smart Beta 2.0 Approach - EDHEC-Risk

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2 An ERI Scientific Beta Publication — Smart Beta 2.0 — April 2013 Copyright © 2013 ERI Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document. Table of Contents Introduction: Taking the Risks of Smart Beta Equity Indices Into Account............................................... 5 1. The Risks of Smart Beta Strategies....................................................................................................................9 2. Controlling the Risks of Smart Beta Investing: The Smart Beta 2.0 Approach...................................21 Conclusion: Smart Beta 2.0 – New Ethics in the Relationship with Investors?.......................................31 Appendix: Overview of Smart Beta Equity Portfolios ....................................................................................35 References...................................................................................................................................................................43 About ERI Scientific Beta.........................................................................................................................................49 ERI Scientific Beta Publications.............................................................................................................................53 Printed in France, April 2013. Copyright © 2013 ERI Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document. The authors can be contacted at contact@scientific beta.com.
An ERI Scientific Beta Publication — Smart Beta 2.0 — April 2013 Copyright © 2013 ERI Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document. 3 Abstract Recent years have seen increasing interest in new forms of indexation, referred to as Smart Beta strategies. Investors are attracted by the performance of these indices compared to traditional capweighted indices. However, by departing from cap-weighting, Smart Beta equity indices introduce new risk factors for investors, and no sufficient attention is 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. This paper puts forth a new approach to Smart Beta Investment, called the Smart Beta 2.0 approach. In fact, 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 to not only 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 discuss 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).
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