The Smart Beta 2.0 Approach - EDHEC-Risk

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.
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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).