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Lyxor describes smart beta factors as the nutrition of investment

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The 10 year old approach to investment, smart beta, is sometimes presented as a new panacea says Nicolas Gaussel, Chief Investment Officer of Lyxor Asset Management.

 
Smart beta ETF trading volumes in the US have doubled in less than two years, standing at USD 340 billion today. The most sophisticated investors such as Dutch pension funds APG and PGGM have allocated a major portion of their investments to smart beta (55 per cent and 40 per cent of their equity investments respectively).
 
Gaussel says it is difficult to define: “The term smart beta is used to refer to all the indices and products whose aim is to ‘improve’ on traditional benchmarks in terms of risk or in terms of return.”
 
Smart beta originated in recent decades of financial research. “Risk-based approaches, such as equal risk contribution or minimum variance, are based on portfolio construction techniques derived from the minimum-variance approach. They aim at correcting some pitfalls of traditional indices such as their excessive concentration on certain risks.”
 
Factor-based approaches are based on statistical analysis of equity price trends, Gaussel says. “Academic research enabled a small number of factors playing a key role in price trends to be identified: beta (sensitivity to the market), a company’s size (large vs small cap), its price in relation to its earnings (value vs growth) and recent equity price performance (momentum), to name but a few. This research resulted in awareness that stock analysis relied at least as much on the market with which it was being compared as on the characteristics of the underlying company.”
 
Smart beta represents a real revolution insofar as it is a precursor of factor investing, Gaussel says.
 
“Investors are no longer happy just to use these factors as a tool for understanding portfolios but are creating portfolios based on the factors they wish to see included.”
 
Gaussel feels that factors are the nutrients of finance. “In the same way as we develop high-protein or low-sugar diets, we can now build or buy “value” portfolios, “small cap” portfolios, etc. New smart beta products, in addition to helping identify the risks inherent in each portfolio, also now ensure healthy competition in active management.”
 
However, Gaussel warns that the speed at which smart beta is developing triggers the risk of potential problems. “The number of factors on offer is rocketing in line with the number of articles written on the subject. As a result, it is easy to get lost in what John Cochrane was the first to call the ‘factor zoo’!” he says.
 
To find their way around the “factor zoo”, Gaussel urges investors to assess the new opportunities by considering three key questions before making any investment: what is the expected outperformance?; How much can I lose, and when will the periods of
underperformance occur? What risk profile is most in line with this investment?

Gaussel feels that the answer to question one lies in looking back as far into the past as possible and making the assumption based on what it tells us about the future. The answer to the second question lies in studying the points that different periods have in common and measuring the related underperformance, while the answer to question three lies in understanding the specific context in which the investment is envisaged.
 
In conclusion, Gaussel believes that smart beta being used in the fixed income space and using risk-based techniques offer an extremely promising area of development for investors.
 
 

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