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EDHEC seeks to debunk Top 10 misconceptions of smart beta strategies

Providers of smart beta investment strategies have allowed too many misconceptions to circulate about the range of investment management types they market, according to research by EDHEC-Risk Institute.

In a paper centred around 10 common but “mistaken” claims about smart beta, the arm of France’s EDHEC Business School said smart beta had drawn fierce criticism from advocates of traditional active management and of passive management alike.

“Smart beta providers have not only responded to such criticism but have also been vocal about the benefits of their respective approaches, without necessarily agreeing with one another,” it said.

Smart beta describes a set of investment strategies based around alternative index construction rather than traditional market capitalisation-based indices.

First on EDHEC’s Top 10 list is the claim that smart beta generates alpha.

Because smart beta aims to outperform standard cap-weighted market indices on a risk-adjusted basis, the paper’s authors said some in the industry claimed smart beta was a way of generating alpha.

“However, we argue that a careful distinction should be made between the returns due to systematic portfolio construction, and returns due to manager skill,” it said.

Looking for alpha in smart beta was not likely to add much value and could instead lead to a risk of underperformance, EDHEC-Risk Institute said.

The institute divided its 10 misconceptions under the three headings of ‘performance drivers’, ‘investability hurdles’ and ‘strategy design choices’.

Mistaken claims under the first heading, according to the research, include “anything beats cap-weighted market indices”, “all smart beta performance comes from value and small-cap exposure” and “smart beta outperforms because it trades against mean reversion”.

Other claims challenged by the paper include “if everyone knows about smart beta, the benefits will disappear” and “a good factor index needs to isolate exposure to the target factor”.

EDHEC-Risk Institute said in its conclusion that many of the misconceptions it was debunking corresponded to over-generalisations that failed to acknowledge that the term ‘smart beta’ covers a huge array of strategies that could have very different properties.

“In a nutshell, our analysis cautions against such over-simplification and calls for a rigorous and detailed analysis of smart beta strategies,” it said.

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