Research: Diversification is key for smart beta products

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Many smart beta strategies are too concentrated to specific factor exposures, which is harming returns, a new paper has found.

Research from the EDHEC Risk Institute and ERI Scientific Beta looked at the impact of the recent falls in the Volkswagen stock and how it affected portfolios.

The research shows that in the short term multi-factor indices should be more diversified. However, it found that managers want to maximise factor exposures and so ran more concentrated portfolios.

“Even though the excessive concentration of cap-weighted indices was one of the motivations for creating smart beta indices, solely taking the factor dimension into account ultimately leads to the indices exposing investors to considerable specific risks,” says the research.

For example, the research looked at the JP Morgan Europe Multi-Factor index, which was very exposed to the risk of the Volkswagen stock at the time of the firm’s emissions scandal, as was the MSCI Europe Diversified Multi Factor index.

These indices respectively had around one and a half and more than two times more Volkswagen stock than the Stoxx Europe 600, and almost 10 times and 16 times more Volkswagen stock than the Scientific Beta Extended Europe Multi-Beta Multi-Strategy EW index.

The study shows that in September, the impact of the Volkswagen scandal is much stronger in concentrated factor indices as opposed to Scientific Beta’s well-diversified smart factor indices which, in fact, outperformed the cap-weighted benchmark.

Following this approach, the index outperformed the Stoxx Europe 600 index by 18 per cent in the week from September 18 to September 25.

Over the same period, an index allocated to the same risk factors but with an excessive concentration underperformed the Stoxx Europe 600 index by 3 per cent.

On 21 September, Volkswagen lost around 20 per cent of its market value and indices that were heavily concentrated in automobile stocks, including Volkswagen, suffered huge losses.

The research says: “As we have emphasised on many occasions, the question of diversification is key for smart beta offerings. In recent years, we have unfortunately seen the emergence of factor indices which, in order to have the strongest exposure to these factors, have favoured concentration, with weightings that did not genuinely take the necessary diversification of specific risk into account, preferring to look for the best factor score.”

According to the latest survey by the Investment Association, 2014 saw a greater use of passives, including smart beta, with 3 per cent of UK assets being in these vehicles.

Though relatively small, IA data suggests 40 per cent of investors are more likely to increase their use of smart beta strategies and 58 per cent are evaluating smart beta to be used along their passive and active equity allocation.