June 2015

EDHEC RESEARCH: A smart idea

ScalesInvestors are keen on smart beta ETFs, says Felix Goltz of the Edhec-Risk Institute, who illustrates the popularity of investment factors.

But investors also place demands on their providers, including evidence that alternative beta works.

It appears that investors show considerable interest in smart beta exchange-traded funds (ETFs) and have strong requirements for them. A quarter of respondents to the Edhec European ETF survey 2014, supported by Amundi ETF & Indexing, already used products tracking smart beta indices, and 40% of them do not currently invest in such products but are considering investing in them in the near future. 

The fact that there are more respondents who are considering an initial investment than there are actually investing implies that we are likely to see strong growth of usage of smart beta ETFs in the future. Moreover, when asked about their priorities for future product development in the  ETF space, smart beta ETFs dominate the list of items mentioned by investors.

In fact, among the six biggest priorities seen by investors, four concern indices relating to smart beta approaches, namely smart beta equity (37%), equity factor (31%), equity style (29%), and smart beta bond (25%). The remaining two items concern emerging market ETFs for stocks (43%) and bonds (27%).

This result is interesting, as there has been a considerable number of product launches in the area of smart beta ETFs. The fact that investors see room for further product development despite numerous launches may be explained by the fact that product launches have focused on relatively few popular strategies representing a small number of risk premia, such as the value premium and defensive equity strategies. 

Given the increasing discussion on harnessing multiple-factor premia from equity investing, including factors such as momentum, size, and quality, among others, it is perhaps not surprising that investors see room for further product development. Indeed, ETFs based on factor indices or style indices (with 31% and 29% respectively) are also among the most widely requested categories for future product development. 

This broad usage of ETFs based on smart beta indices, as well as the wishes for additional development, may be explained by the favourable perception that respondents have of smart beta indices as tools for improving their investment process. 

More than two-thirds of respondents (71%) think that smart beta indices provide significant potential to outperform cap-weighted indices in the long term and more than four respondents out of five (81%) think that they avoid cap-weighted indices being concentrated in very few stocks or sectors.

The same proportion of respondents thinks that diversification across several weighting methodologies allows risk to be reduced and adds value, while 82% of respondents agree that smart beta indices allow factor risk premia, such as value and small-cap, to be captured. Thus, capturing factor premia is the prime motivation for investment in smart beta ETFs for a vast majority of respondents.

For the first time this year, investors were asked about their appreciation of the different factors inherent in equity strategies and how these factors were explaining the performance of these strategies (see table). It appears that none of the seven factors proposed to respondents obtained a poor score. On a scale from 0 (no confidence that the factor will be rewarded) to 5 (high confidence), the average scores of the factors range from 2.89 (low volatility factor) to 3.39 (value factor). 

Value and small cap are the two factors considered by respondents as the most likely to be rewarded, with scores of 3.39 and 3.22, respectively. This is not surprising, as the existence of the value premium and small-cap premium has been largely developed in the literature for a long time.

We also note that only a very small share of respondents declare they are not familiar with the factors proposed. They range from 4.07%, for the value factor to 7.56%, for the profit factor.

However, respondents have some requirements to consider the selection of a given set of factors in their investment approach. Respondents are first of all concerned by ease of implementation and low turnover and transaction costs, with a score of 3.66, closely followed by a rational risk premium, with a score of 3.61, on a scale from 0 to 5. Also important to them, with a score of 3.45, is that the factor premium should be documented in extensive empirical literature. Indeed, all propositions receive quite a high score, as the lowest was 2.77.

Interestingly, an even greater share of respondents (88%) than for all other statements about smart beta indices agree that smart beta indices require full transparency on methodology and risk analytics. 

Transparency is not only the best protection against the risks arising from conflicts of interests, it is also instrumental to improving the informational efficiency of the indexing industry. 

In view of the increased diversification and sophistication of the rapidly growing indexing industry, achieving informational efficiency should be a key priority. While transparency is important for market indices, i.e. indices that aim to represent a given market or segment, it  is all the more so for smart  beta indices. 

Indeed, while these new forms of indices can provide investors with improved risk-reward profiles or other benefits, they bring distinct risks of their own. 

Unfortunately, these indices’ low level of transparency, which is routinely justified by the  use of proprietary models,  makes the evaluation of risks difficult.

Equity risk factrors table

Felix Goltz is head of applied research at the Edhec-Risk Institute

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