Scientific Beta

Financial News: "Prof. Noël Amenc, Director, EDHEC Risk Institute and CEO, ERI Scientific Beta: "For me, it is a two-fold definition: smart beta means, first, being exposed to well rewarded factors and, second, being well diversified in that exposure"."

Financial News 08/12/2014

"(...) Financial News asked practitioners in each field for their insights on smart beta, whether smart products live up to their name and where the market might develop next. (...) THE ACADEMIC Prof. Noël Amenc, Director, EDHEC Risk Institute and CEO, ERI Scientific Beta. What do you mean when you talk about smart beta? There are two definitions due to market trends. The first concerns portfolio diversification, and “smart” refers to the stock weighting. It’s a term for strategies like equal weight, minimum volatility and max decorrelation. You are effectively saying weighting by market capitalisation is not smart because it leads to a benchmark that is excessively concentrated and poorly diversified. The other part of the definition is about the beta, and people also refer to “alternative beta”. Cap-weighted indices do not provide good exposure to risk factors because they are only exposed to large growth stocks that in the long run are not well rewarded. (...) For me, it is a two-fold definition: smart beta means, first, being exposed to well rewarded factors and, second, being well diversified in that exposure. (...) Does a smart beta index always result in a smart ETF? There are different aspects. First, you don’t want too much slippage between the performance of the index and ETF, which is a question of investability, where the turnover and liquidity of the index are replicated. It is also important to ensure the index’s past performance is a fair representation of the future. That is robustness. (...) If you mix relative robustness and absolute robustness, you have a very robust, smart ETF. What next for smart beta in the ETF space? The next step will be allocation across indices. There are now a large number of ETFs or indices giving a wide range of factor exposures. The scope for sophistication in developing new indices in future has a counterpart in a lack of robustness. Because all the academic literature results have been implemented, index innovation now is mainly about outperformance through a kind of back-tested stock-picking. That is absolutely not robust. The main risks in smart beta innovation are factor fishing and data mining. Instead, we should look to another part of the academic literature that is rarely implemented by passive investment professionals, which is dynamic allocation across indices. (...)"