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Special Report: Here are the Major Risks of Smart Beta Strategies

By Garrett Keyes November 1, 2018

If smart beta investments are used to drive returns, investment risk may be riding shotgun. Part 4 of a 5-part Special Report on Smart Beta.

Smart beta investments are meant to offer the best of both worlds when it comes to active and passive investment strategies. But they still carry associated investment risks, experts say.

Despite being referred to by many names, smart beta is widely known as a mash-up of active and passive investment strategies meant to marry the best parts of each style’s portfolio construction, Morningstar analyst Ben Johnson says. But many different variations of smart beta investments exist, and their associated risks can differ dramatically. Every strategy is created differently, and investors will see distinct risks across different strategies, Johnson says.

Earlier this year, the ERI Scientific Beta investing initiative said the “risk implications of smart beta are not fully understood,” FA-IQ sister publication Ignites Europe reported. Yet three common risks seem characteristic to smart beta: lack of investment understanding; industry or geographic concentration; and poor investor behavior.

Lack of understanding and over-complexity

Smart beta investments are composed of funds and indexes targeting a variety of different industries, sectors, and markets. And for advisors or investors, trying to understand the risks that exist across each smart beta investment can be a real challenge. The difficulty in understanding the instruments is in part due to investment overcomplexity, Martin Raab, co-author of Wiley’s "Beyond Smart Beta" and founding partner of Sugarwood Financial Partners, says. The underlying benchmarks for some smart beta strategies can be very complex with varying degrees of opaqueness. The margin investors see as they move into multifactor strategies grows relative to the level of complexity, according to Raab. Across smart beta investments, it can be good guidance for advisors looking to use the instruments to keep it simple and avoid this trap, he says. Chris Brightman of Research Affiliates agrees. He says, “If it’s complicated, it’s not ‘smart’ beta.”

Investors might unintentionally ignore questions of market exposure when looking at smart beta funds.
Eric Shirbini
ERI Scientific Beta

Even if investments are kept simple, industry research for smart beta instruments is crucial to an advisor’s comprehension of the product, Johnson says. This means understanding the constituents within a particular smart beta fund. For instance, 40% of people are not aware that the MSCI world index is nothing more than a 54% bet on the U.S. market, because of its 54% exposure to the U.S. dollar, even though it sounds global, says Raab. If this index is a major constituent of a fund purported to perform a global play, then it might not be doing the job intended. It’s all about industry research and taking some time to look at each specific investment strategy, he says. And Johnson agrees.

Every smart beta instrument is created differently with distinct risks across a variety of strategies. And because smart beta investments are defined by index methodology, it is very important to understand the research process used by the manufacturer, he says. Knowing the process of portfolio construction for smart beta funds as well as index methodology is of paramount importance, Johnson says.

Geographic or industry exposure risk

Chris Brightman says geographic risks should not exist within smart beta funds because in principle, smart beta funds tend to be very diversified and not concentrated in a single sector. But ERI Scientific Beta director Eric Shirbini says investors might unintentionally ignore questions of market exposure when looking at smart beta funds. They shouldn’t. Macro exposure biases can lead to interaction effects with other factors and asset classes, says Raab. And consequently, geographic risk may follow.

It’s not just about trusting the names of investments, because some indices used in smart beta portfolios are highly correlated to others but simply have different names, says Raab.

Martin Raab

It’s all about correlation when it comes to geographic risk, Raab says. For instance, due to the interconnectedness of European markets and companies, having an investment in a Netherlands MSCI index may cause the investor’s portfolio to have some unintended correlation to other investments in the region, despite the instrument leading the investor to believe it only targets the Netherlands. Similarly, holding the MSCI world index could give investors unintended exposure to the Netherlands as its part of the index’s 14.4% European (excluding the U.K.) exposure.

Exiting smart beta investments too early

Lastly, investors and advisors using smart beta may fall victim to the risks of poor behavior, Johnson says. There are periods where smart beta investments will underperform. And during those stretches of underperformance, investors might struggle, he says.

Smart beta investments are long-term investment strategies that take time to properly pay off. Investors unable to show resolve during stretches of underperformance will struggle to receive proper smart beta payoff as smart beta follows an index methodology in terms of its long-term payoff.

Some people think that risk means daily standard deviation of risk, says Brightman. But that belief can lead to a buy-high and sell-low mentality – and that simply won’t work with smart beta. For an individual planning to invest for decades to come, the risks of smart beta investments are low but investors using smart beta the wrong way – without a long-term perspective – may be in for trouble.

Next: Where to next for smart beta.