Scientific Beta

Risk.net: "A recent paper published by the indexing arm of EDHEC-Risk Institute found that smart beta indexes frequently incorporate untested proprietary adjustments into their methodologies - something that could increase uncertainty for investors - and often ignore academic research in the process."

Risk.net 14/01/2015

"(...) A recent paper published by the indexing arm of EDHEC-Risk Institute found that smart beta indexes frequently incorporate untested proprietary adjustments into their methodologies - something that could increase uncertainty for investors - and often ignore academic research in the process. The paper looked at a selection of indexes to examine their relative robustness - defined as the ability to perform in line with market conditions - and their absolute robustness - the ability to outperform the market. "The potential opportunity is very well documented, but sometimes investors may not be aware, relative to popular benchmarks, that they're building up a magnitude of risk," says Felix Goltz, head of applied research at EDHEC-Risk in Nice and one of the paper's authors. Goltz says index providers should spell out the risks more clearly. But he adds that investors need to carry out due diligence and look more closely at a smart beta index's methodology to see whether it derives from academic consensus on how to build a successful strategy. If the methodology strays too far from this consensus, then investors - especially those in the less sophisticated retail space - may find it hard to assess the risks associated with the index, Goltz says. "These indexes are transparent, so you'll be able to find how they define momentum in most cases. But often, the communication still basically says: "These are the standard factors - they are academically justified"." Goltz says that while it would be straightforward for an index provider to show how its methodology could affect an index's returns, this is typically not done by the industry. (...)"