Smart 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.”