(July 26, 2013) – Smart beta strategies are all about offering a lot at a low price—or so say the marketing materials—but they still entail trade-offs.
Risk-based indexes, for example, have been designed to capture equity risk premia more effectively than traditional cap-weighed indexes. But, as Lyxor Asset Management’s latest white paper has pointed out, they do so by sacrificing liquidity.
Minimum variance products have been a main driver of assets into smart beta, according to authors Zélia Cazalet, Pierre Grinson, and Thierry Roncalli. The three quantitative researchers focused on this class of indexing, as well as low-volatility strategies more broadly, in their paper, “The Smart Beta Indexing Puzzle.”
A 10% reduction in price volatility for a modeled equities index entailed a 3% to 4% rise in tracking error volatility, the authors found. These findings were based on a data set of S&P 500 performance from 1990 through 2012.
Similarly, reduced volatility brings with it greater diversification, but reduced liquidity and dampened performance during bull markets, according to Cazalet, Grinson, and Roncalli.
For this last reason, allocating to an indexed low-volatility strategy would be making a bet on market performance: it hedges downside risk, and hinders upside potential.
Smart beta strategies also tend to have higher price tags, several consultants pointed out to aiCIO recently.
“It’s not a lot, but if the reason you’re investing passively is to keep the costs down it might be enough of a reason not to,” Cardano’s Client Director Phil Page said.
“It comes down to if you think you’d be better off paying the extra few basis points in return for a better return,” he said. “Advocates would also argue that it produces a more stable return profile as it avoids price excesses and potentially defaults.”
Zélia Cazalet, Pierre Grinson, and Thierry Roncalli’s entire paper for Lyxor—”The Smart Beta Indexing Puzzle”—is available here.
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