Scientific Beta

Although gaining explicit exposure to priced risk factors is expected to provide good long-term risk-adjusted performance, investing in these very factors also exposes investors to a number of hidden or implicit risks that could be important drivers of short-term performance. To reconcile such risk exposures with investors’ preferences, it is crucial that they be well documented. With cap-weighted indices, which represent the default option in terms of a passive investment reference, being increasingly called into question, smart beta’s main fiduciary message is that there is no best solution in general, but rather a best solution that allows the investor’s fiduciary choices to be executed in the most efficient way.

Although gaining explicit exposure to priced risk factors is expected to provide good long-term risk-adjusted performance, investing in these very factors also exposes investors to a number of hidden or implicit risks that could be important drivers of short-term performance. To reconcile such risk exposures with investors’ preferences, it is crucial that they be well documented.

With cap-weighted indices, which represent the default option in terms of a passive investment reference, being increasingly called into question, smart beta’s main fiduciary message is that there is no best solution in general, but rather a best solution that allows the investor’s fiduciary choices to be executed in the most efficient way. Ultimately, the choice on managing these risks is a key fiduciary decision that cannot be left to the discretion of an index provider that has no status to do so. Asset owners should also start improving governance practices by starting a risk conversation on smart beta investments with stakeholders.