The stratospheric rise of smart beta has provoked intense debate in recent years. Edhec Risk Institute feel much of this debate has been driven by misconceptions about smart beta strategies.
The institute has now published a list of the most common misconceptions about smart beta, in three separate areas of smart beta performance and risk. They are as follows:
Performance drivers
- The hiding game: “smart beta generates alpha”
- The monkey portfolio claim: “anything beats cap-weighted market indices”
- The value and size myth: “all smart beta performance comes from value and small-cap exposure”
- The rebalancing fantasy: “smart beta outperforms because it trades against mean reversion”
Investability hurdles
- The liquidity concern: “smart beta requires positions to be held in highly illiquid stocks”
- The turnover critique: “smart beta necessarily leads to high turnover”
- The crowding hypothesis: “if everyone knows about smart beta the benefits will disappear“
Strategy design choices
- The concentration fallacy: “a good factor index should provide a strong tilt to the desired factor”
- The factor fishing licence: “a good factor index requires a sophisticated scoring approach”
- The factor purity argument: “a good factor index needs to isolate exposure to the target factor”
The firm’s analysis shows that more often than not, superficially convincing claims about smart beta strategies are in fact erroneous. Challenging conventional wisdom by reviewing academic literature and empirical evidence, the institute believes, will lead to more balanced conclusions and a more nuanced understanding of the benefits and risks of smart beta strategies.
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