Investors should pay more attention to market exposure when conducting analyses of smart beta strategies, according to research from ERI Scientific Beta, an affiliate of EDHEC-Risk Institute.

Professor Noël Amenc, Director of EDHEC-Risk Institute and CEO of ERI Scientific Beta.

In a new research paper entitled “Mind the Gap: On the Importance of Understanding and Controlling Market Risk in Smart Beta Strategies”, the smart beta index provider argues that most research proposing new multi-factor investment methodologies essentially ignores exposure to the market factor, which is the most consensual among all factors and often the most influential factor for a strategy.

The study found that, over the long term, adjusting the market beta of a multi-factor strategy with that of a cap-weighted index corresponds to an annual gain in performance of more than 1%.

More generally, the authors demonstrate that different levels of market beta have a strong impact on the performance and risk of smart beta strategies in terms of long-term returns, volatility, and the dependence of performance on market conditions.

Commenting on the paper, Noël Amenc, CEO of ERI Scientific Beta, said, “The Multi-Beta Multi-Strategy Six-Factor High Factor Intensity Equal Weight offering has been Scientific Beta’s flagship offering since last year.

“There are now two versions of this offering: with and without market beta control. This distinction, with and without Market Beta Adjustment (MBA), corresponds to a very straightforward approach since these two versions have the same Sharpe ratio over the long term. The version without the MBA risk control option has a defensive beta bias and as such has lower volatility than that of the market and given its low market beta bias, does not allow one to benefit from all the returns of the markets.

“The MBA version, whether it is implemented in the form of overlay or leveraged, logically has volatility that is quite similar to that of the market, since the strategy is 100% exposed to the volatility of the market, and therefore constructs its improvement in the Sharpe ratio over the long term on the excess return procured by factor premia.

“Ultimately the version without MBA is probably the version that corresponds best to an absolute risk budgeting, and therefore cap-weighted benchmark substitution, approach. The version with MBA corresponds best to a relative risk budgeting (conditional relative performance, tracking error) approach and as such is surely recommended for investors who are concerned about replacing an active manager.”