Smart-Beta Risks Not Clear Enough

November 19, 2013

Edhec-Risk talks smart-beta risks and index transparency issues.

[This interview previously appeared on our sister site, IndexUniverse.eu.]

 

In March this year, Edhec-Risk Institute made headlines when it announced it had launched a new smart beta platform offering investors free data. The move saw several commercial index providers speak out against the move arguing that data provision is part of a commercial business model and necessarily paid for.

Since then Edhec has been highly vocal over its position on transparency and data availability. It has spoken out against the International Organisation of Securities Commissions (IOSCO's) guidelines for ETFs arguing that it side-stepped the matter of index transparency. Most recently it took issue with the European Fund and Asset Management Association’s (EFAMA's) criticism of the rules that European regulator, European Securities and Markets Authority (ESMA), laid out.

It even made several calls for users to insist on full transparency earlier this year.

IU.eu’s European editor, Rebecca Hampson, talks to Frederic Ducoulombier, director at Edhec-Risk in Asia, about why investors should have access to index data and why it is being pushed so fiercely.

 

IU: Why do you keep pushing this idea that we need more transparency and index data should be free?

Frederic Ducoulombier: We are trying to achieve transparency for the investor. Asset allocation is the most important decision for long-term investor welfare and asset allocation decisions and implementation crucially depend upon indices. It is critical that investors are able to see all the information required so they can select indices and then manage their indexed investments. At the moment that is just not the case and this is especially true in the smart beta space where new indices are being brought out that no longer try to represent the market but instead aim to deliver a specific risk/return profile.

Investors should be in a position to analyse how this risk/return profile is engineered and how the index should be expected to perform in different market conditions.

IU: What is the problem with smart beta?

 

FD: These newer indices have the potential to deliver significant gains in terms of long-term risk adjusted performance, but they also entail particular risks, which can result in their underperforming the generally accepted benchmarks in some market conditions.

Firstly, they come with different factor exposures (systematic risk) relative to the more established market cap-weighted indices. Then, they are built on different assumptions, choices and methodologies, and this introduces model and parameter estimation risk. Even indices that appear to be following similar strategies have different exposures, turnover and so on.

The problem is that none of these risks are documented well enough. Access to information is restricted, which means investors don’t have the ability to understand and manage these risks. Any independent analysis that would contribute to a better understanding of these innovations, as well as to further innovation, is discouraged. Altogether, the smart beta market is inefficent and this is detrimental to its development.

 

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