(March 20, 2013) — Investors considering smart beta approaches are being swayed by biased sales and marketing techniques as the real risk and performance of strategies is often hidden, a new paper has claimed.
Poor information and limited access to data means investors are often left with a skewed version of events, the Edhec-Risk Institute has claimed.
“Investment in smart beta presupposes measurement of the systematic risk factors and integration of the factors, not only in absolute terms to evaluate the real risk-adjusted performance created by better diversification of the benchmark, but also in relative terms to limit the tracking error risk and therefore the risk of underperformance in comparison with the cap-weighted index,” the paper said.
However, most providers of the strategy are found wanting in this regard, the paper entitled “Smart beta 2.0 – Taking the risks of new equity benchmarks into account” reported.
“What is the minimal level of information which the smart beta investor should possess in order to evaluate genuine performance and risks? In the area of smart beta indices, one is forced to conclude that the situation is currently inadequate,” the authors asserted.
Access to data on performance, composition, and risk of smart beta indices is either restricted by the provider for proprietary reasons, or too costly for an investor, the paper said, which makes analysis and like-for-like comparisons very tricky.
Additionally, research on smart beta has not yet reached sufficiency in either volume or quality for investors to make up their own minds, the organisation claimed.
Sales and marketing teams’ supposed scientific evidence on their own products cause confusion for investors, the institute said. “Research in the area of smart beta is polluted by conflicts of interest and the difficulties in distinguishing between what is scientific evidence and what stems from the author’s desire to promote a particular weighting scheme.”
The paper proposes a method of cutting through the spin from providers and would allow investors access to data to help them make an informed choice.
It would also permit investors to take control of the risk they want in their portfolio, rather than (often unknowingly) agree to set risk parameters.
“Rather than accepting prepackaged choices of alternative equity betas, investors should be able to explore different smart beta index construction methods in order to construct a benchmark that corresponds to their own choice of risks,” the authors concluded. “For the sake of transparency about the risks they are taking, they also need to be able to analyse risk and performance of smart beta strategies openly rather than depend on the sole analysis published by the providers of particular strategies. It is against the backdrop of these requirements from investors that we argue for the need for a second generation of smart beta approaches.”
Their final words on the subject: “Smart beta market practices are no different from those of active managers who like to choose the periods of comparison with their peers.”
To read the full paper, click here.
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