Smart beta indices platform provider, ERI Scientific Beta, has said that more attention should be paid to market exposure when conducting analyses of smart beta strategies.
The firm’s research “Mind the Gap: On the importance of understanding and controlling market risk in smart beta strategies” said that many new multi-factor investment methodologies ignored exposure to the market factor which was often the most important factor for a strategy.
The study also found that over the long term, adjusting the market beta of a multi-factor strategy with that of a cap-weighted index contributed to an annual gain in performance of more than one per cent.
ERI Scientific Beta’s chief executive, Noel Amenc explained that its flagship offering, the Multi-Beta Multi-Strategy Six-Factor High Factor Intensity Equal Weight, offered two versions: with and without market beta control.
“This distinction, with and without market beta adjustment (MBA), corresponds to a very straightforward approach since these two versions have the same Sharpe ratio over the long term,” he said.
“The version without the MBA risk control option has a defensive beta bias and as such has lower volatility than that of the market, and given its low market beta bias, does not allow one to benefit from all the returns of the markets.
“The MBA version, whether it is implemented in the form of overlay or leveraged, logically has volatility that is quite similar to that of the market, since the strategy is 100 per cent exposed to the volatility of the market, and therefore constructs its improvement in the Sharpe ratio over the long term on the excess return procured by factor premia.”
Noel stressed, that according to the research findings, that ultimately the version without MBA was probably the version which corresponded best to an absolute risk budgeting, and therefore cap-weighted benchmark substitution, approach while the second option corresponded best to a relative risk budgeting such as conditional relative performance, tracking error approach.
Therefore, the second version as such should be recommended for investors concerned about replacing an active manager, he said.
