Scientific Beta

The results of the paper show that adopting risk control schemes in portfolio optimisation does not deteriorate tail risk. From a practical perspective, managing volatility and tracking error is sufficient for managing total tail risk in the context of the different smart beta strategies and different risk control schemes considered in the paper.

To overcome the deficiencies of cap-weighted indices, smart beta strategies have been proposed. They employ weighting schemes that deviate from cap-weighting, deal with the problem of concentration and allow for a flexible index construction process in which the index can be tilted to better rewarded factors.

Along with the better risk-adjusted performance, however, investors in smart beta strategies are exposed to additional risks. The weighting scheme may lead to a temporary over-weighting or under-weighting of a given sector or country relative to the corresponding cap-weighted benchmark which may lead to periodic underperformance. Also, the better risk-adjusted performance necessarily comes at the cost of some tracking error to the respective cap-weighted benchmark. Both aspects recognise that cap-weighted indices, albeit inefficient portfolios, will continue to be a reference point and therefore those relative risks need to be managed.

Finally, any departure from cap-weighting is a departure from the goal of representing the market and should therefore be based on some other objective, which often takes the form of a goal in an optimisation problem. The various parameter inputs required to solve the problem expose the weighting scheme to sample risk which differs from one strategy to another. It makes sense to consider combining various strategies into a multi-strategy index in order to diversify away sample risk, but also to enjoy better risk-adjusted returns that come from smoothing the conditional performance.

Country or sector risk can be avoided through standard techniques. Tracking error risk can be managed efficiently through the classical core-satellite method and sample risk can be diversified away through a multi-strategy index. From a practical perspective, however, it is important to verify whether by diversifying some aspects of risk we are not magnifying others, such as tail risk.

Our main findings in the paper are that there is no evidence that controlling for country or sector risk increases tail risk, both in terms of absolute and relative returns. Furthermore, as expected, tracking error controls reduce the total tail risk of relative returns but this is mainly through the reduction of tracking error itself with no additional benefits. Finally, building a multi-strategy portfolio diversifies the total tail risk of relative returns; but again, the most significant factor is the diversification of the tracking error.

In summary, our results show that adopting risk control schemes in portfolio optimisation does not deteriorate tail risk. From a practical perspective, managing volatility and tracking error is sufficient for managing total tail risk in the context of the different smart beta strategies and different risk control schemes considered in the paper.