Scientific Beta

Frequent changes in the index methodology is quite a common occurrence in the smart beta industry. While it often stems from the desire of index providers to innovate, it sometimes creates inconsistencies between different product offerings across time. We provide concrete examples from industry practices and analyse the possible implications of such inconsistencies, namely the changes in factor definitions, factor selection and portfolio construction principles. Inconsistency in index methodology directly contradicts the principles of long-term investing. It is well known that investors need to stay the course with an adopted investment approach to avoid relying on fads and suffering from poor returns. 

Frequent changes in the index methodology is quite a common occurrence in the smart beta industry. While it often stems from the desire of index providers to innovate, it sometimes creates inconsistencies between different product offerings across time. We provide concrete examples from industry practices and analyse the possible implications of such inconsistencies, namely the changes in factor definitions, factor selection and portfolio construction principles. Inconsistency in index methodology directly contradicts the principles of long-term investing. It is well known that investors need to stay the course with an adopted investment approach to avoid relying on fads and suffering from poor returns. Time-varying index methodologies also introduce significant data-mining risks. Our analysis suggests that even a limited degree of flexibility in index construction may lead to highly-inflated performance in backtests. To avoid such risks, product providers should closely stick to their investment principles and limit the flexibility in terms of the choices they have by being consistent with their methodological framework. When changes do occur, it is important that investors be informed about the motivations behind such index changes and the performance across offerings that were favoured by a provider at different points in time. Transparency on changes in index offerings and methodologies is crucial as it allows investors to evaluate the quality of different index offerings.