Smart beta investors taking 'considerable' risk

Risk1Index promoters do not document or explicitly control risks within their smart beta index offerings, researchers claim, which means that investors are taking a 'considerable' risk when they choose these new equity benchmarks.

The Edhec-Risk Institute says the “inadequate” levels of information and risk management about smart beta indices “calls into question” the robustness of their performance.

Smart beta indices have risen in popularity in recent years, propelled partly by the hunt for outperformance against traditional benchmarks for fees cheaper than those that active managers charge.

A senior manager in the exchange-traded fund (ETF) industry, who did not want to be named, tells Funds Europe that risks such as liquidity are not always highlighted by index providers when they sell their products to users.

Performance looks great on paper but then you drill down you see that in certain market conditions some securities were difficult to get out of, making an index too risky.”

ETF providers are users of smart beta indices and a hallmark of the industry is transparency.

In a study - Smart Beta 2.0 - Edhec researchers Noël Amenc, Felix Goltz and Lionel Martellini say that to deal with the problem, the choice of systematic risk factors for smart beta benchmarks should be made explicitly clear.

Also, the choice should be made by the investor and not by the index promoter, they say.

However, the researchers add that the choice of systemic risk factor, and therefore the associated risk control, is compatible with smart beta benchmark performance, meaning it is possible to maintain performance objectives with so-called smart beta 2.0 indices without excessively exposing these new benchmarks to size or liquidity risk in comparison with cap-weighted indices.

Funds Europe contacted two major index providers but had not received comment by deadline.

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