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Portfolio > Portfolio Construction

3 ‘Hidden Risks’ of Smart Beta

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businessman with magnifying glassSmart beta strategies have several “hidden risks” that providers don’t always document fully, a study by Scientific Beta found, and these risks could have a significant impact on portfolio performance. In a white paper released Tuesday, Scientific Beta suggested investors should be savvier in their use of smart beta products and recommended that the industry needs to improve its disclosure of risks.

“Although gaining explicit exposure to priced risk factors is expected to provide good long-term risk-adjusted performance, investing in these factors also exposes investors to several non-priced risks that could be important drivers of short-term risk performance,” said ERI Scientific Beta CEO Noël Amenc in a statement. She warned that managing these risks is a “key fiduciary decision” and should not be left to the index provider, which may not provide full documentation. ERI Scientific Beta is a provider of smart beta index platforms.

In his paper, “Misconceptions and Mis-selling in Smart Beta: Improving the Risk Conversation in the Smart Beta Space,” author Eric Shirbini, global research and investment solutions director with Scientific Beta, noted drivers of short-term performance in smart beta contain certain dangers, such as market risk bias, macroeconomic risks and sector/geographical risks. Too often, it seems, investors choose a strategy by lowest fees and past performance, and ignore risk factors, the paper states.

The key hidden exposures noted in the paper are:

1) Market beta: Although market beta drives performance of multi-factor indexes, market exposure may be ignored while the focus is on factor intensity. “This market beta, if left uncontrolled, can lead to significant biases in performance and such biases are often left undocumented,” Shirbini writes. These biases can have two adverse effects. First is “the strategy could be losing out on the long-term equity market risk premium, which accounts for a significant portion of long-term performance of any long-only equity strategy,” while, secondly, “uncontrolled market risk exposure can also lead to pronounced differences in short-term performance since market exposure heavily influences the conditional performance of multi-factor strategies.”

2)  Factor strategies are exposed to macroeconomic risks: This may not be something investors are aware of due to lack of disclosure, however, macro exposure can lead to “interaction effects with other factors and asset classes.” For example, smart beta strategies more sensitive to a specific asset class may interact with other parts of the portfolio, such as fixed income, thus reducing diversification within the portfolio. Noted Shirbini, “A multi-factor portfolio may lack diversification across factors if several risk factors are sensitive to the same macro driver. In this case, having a constant and balanced (beta) exposure to multiple rewarded risk factors may not necessarily improve the diversification of the portfolio. Instead, focusing on the diversification of factor risk premia within a macroeconomic regime would be more important than maintaining balanced exposure across multiple factors.”

3) Managing unrewarded risks: Index providers don’t always note “implicit unrewarded bets” to which the product may be exposed. “Sector and region-specific bets are not risks that correspond to price factors,” the report stated. Therefore, these must be documented by the provider and “validated” by investors. One study showed how “smart beta strategies can lead to strong biases compared to the cap-weighted benchmark, if left unmanaged. These biases often have more impact on performance in the short and medium term than the risk premium associated with low volatility over the long term.”

In the paper, Shirbini concludes that “asset owners should also start improving governance practices by starting a risk conversation on smart beta investments with stakeholders,” asking investors questions about risk tolerance, how that aligns with investment beliefs, and how these interactions across the policy portfolio should be evaluated and managed.

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