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Beverly Chandler

Paper warns of over generalising on smart beta


Edhec Risk’s smart beta platform provider, ERI Scientific Beta, has published a research paper warning against simplistic explanations of smart beta performance.

 ‘Smart Beta is not Monkey Business’ is published in the latest issue of the Journal of Index Investing and rejects the claims of ‘monkey portfolio’ proponents, who argue not only that all smart beta strategies generate positive value and small-cap exposure, which fully explains their outperformance, but also that similar results are obtained by any random portfolio strategy, including the inverse of such strategies. The ‘monkey’ label comes from the idea that a monkey would be able to generate similar performance through a random selection of stocks.
The ERI Scientific Beta paper analyses these claims using test portfolios which follow commonly-employed methodologies for explicit factor-tilted indices. The results directly invalidate all of the above claims. In particular, the results show that many smart beta strategies display exposure to factors other than value or small cap, as well as pronounced differences in factor exposures across different strategies.
The firm writes that in addition, and perhaps reassuringly, the inverse of these strategies generates inferior performance. “That the findings directly contradict the monkey portfolio claims can be explained by the set of test portfolios. While the monkey portfolio arguments may hold for the particular smart beta specifications tested by its proponents, they do not hold in general. Specifically, the research conducted shows that only the indices termed ‘fundamental’ behave like monkey portfolios, on the one hand because their method of construction is based on accounting criteria that are not associated with any statistically significant risk premium over the long term, and on the other because their high level of concentration results in a large proportion of specific risk that leads to performance that lacks robustness and is therefore random.”
ERI Scientific Beta believes that an important implication of the results is that one should take care to avoid over-generalising from testing particular specifications of smart beta. “For the explicit factor-tilted strategies tested in this new research, the results imply that a careful assessment of investment philosophy and index design is indeed relevant as such strategies do not behave like ‘monkey’ portfolios.”

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