ERI ‘casts doubts’ over smart beta

Investors need to be warned that passive funds tracking specialised indices only work in certain markets and do not guarantee outperformance, a research paper has claimed.

Some passive funds track an index that has been constructed based on a certain factor. This criterion can range from a focus on companies that pay dividends to a decision to hold an equal weighting of each stock within an index.

Funds that follow such specialised indices have become known as ‘smart beta’ vehicles.

Article continues after advert

ERI Scientific Beta, which provides smart beta products, has said those smart beta funds that track equally-weighted indices may not always outperform, in spite of claims by proponents that they are all-weather investments.

An ‘equally-weighted’ approach is designed to overcome the supposedly inherent problems within a conventional market capitalisation-weighted index, which sees larger companies dominate the index. Such indices have been criticised for placing too much emphasis on overvalued stocks while giving too little prominence to undervalued companies.

The solution, according to smart beta enthusiasts, is a product that assigns the same weighting to each stock within an index – for example, a FTSE 100 tracker that has 1 per cent of its assets invested in each stock within the index.

This equally-weighted approach is designed to give more exposure to the lower end of the index, the part that is perceived to create more ‘value’.

Smart beta products that label themselves as having a ‘value’ strategy can take a variety of approaches but the most basic is being equally-weighted.

But ERI Scientific Beta, which is the index arm of the EDHEC-Risk Institute, has claimed there is no evidence such funds can consistently outperform.

In a study entitled ‘Robustness of Smart Beta Strategies’, ERI Scientific Beta put forward the case for a diversified portfolio of smart beta factors.

The study said there was “no positive and statistically significant long-term risk premium for a ‘value’ factor definition that relies on the approach termed ‘fundamental’, even though this approach is highly popular with investors and index providers”.

The ERI Scientific Beta study claimed many such approaches could only be described as “relatively robust”, in that they only outperform if market conditions at the time favour such a strategy rather than outperform throughout a market cycle.

The study warned: “The existence of so many smart beta strategies, coupled with so little information on justifications of their performances, could cast doubts over the very usefulness of these strategies.”

It cited a survey that the EDHEC-Risk Institute had undertaken that found the primary reason respondents chose not to invest in smart beta products was that they were unsure about the “robustness” of the claimed outperformance of the various strategies.

The study instead advocated an approach that would attempt to generate “absolute robustness”, which would be a “strategy shown to outperform, irrespective of prevailing market conditions”.