Smart-Beta Risks Not Clear Enough

Smart-Beta Risks Not Clear Enough

By Rebecca Hampson

November 19, 2013

In March this year, Edhec-Risk Institute made headlines when it announced it had launched a new smart beta platform offering investors free data. The move saw several commercial indexproviders speak out against the move arguing that data provision is part of a commercial business model and necessarily paid for. Since then Edhec has been highly vocal over its position on transparency and data availability. It has spoken out against the International Organisation of Securities Commissions (IOSCO’s) guidelines for ETFs arguing that it side-stepped the matter of index transparency. Most recently it took issue with the European Fund and Asset Management Association’s (EFAMA’s) criticism of the rules that European regulator, European Securities and Markets Authority (ESMA), laid out. It even made several calls for users to insist on full transparency earlier this year. IU.eu’s European editor, Rebecca Hampson, talks to Frederic Ducoulombier, director at Edhec-Risk in Asia, about why investors should have access to index data and why it is being pushed so fiercely. IU: Why do you keep pushing this idea that we need more transparency and index data should be free?

Frederic Ducoulombier: We are trying to achieve transparency for the investor. Asset allocation is the most important decision for long-term investor welfare and asset allocation decisions and implementation crucially depend upon indices. It is critical that investors are able to see all the information required so they can select indices and then manage their indexed investments. At the moment that is just not the case and this is especially true in the smart beta space where new indices are being brought out that no longer try to represent the market but instead aim to deliver a specific risk/return profile.

Investors should be in a position to analyse how this risk/return profile is engineered and how the index should be expected to perform in different market conditions.

IU: What is the problem with smart beta?

FD: These newer indices have the potential to deliver significant gains in terms of long-term risk adjusted performance, but they also entail particular risks, which can result in their underperforming the generally accepted benchmarks in some market conditions.

Firstly, they come with different factor exposures (systematic risk) relative to the more established market cap-weighted indices. Then, they are built on different assumptions, choices and methodologies, and this introduces model and parameter estimation risk. Even indices that appear to be following similar strategies have different exposures, turnover and so on.

The problem is that none of these risks are documented well enough. Access to information is restricted, which means investors don’t have the ability to understand and manage these risks. Any independent analysis that would contribute to a better understanding of these innovations, as well as to further innovation, is discouraged. Altogether, the smart beta market is inefficent and this is detrimental to its development.

IU: So, is it just smart beta where there is a problem?

FD: The lack of transparency is general but it is particularly problematic when approaching these newer, and typically more sophisticated, indices that are being promoted on the basis of back-tests.

IU: Are investors aware of these transparency issues?

FD: Pension funds, insurance companies and other end-investors, are aware of the issues surrounding indices and are not satisfied with the level of transparency they are currently being offered.

IU: The indexing sector is growing and it has managed to self-regulate thus far. Managing an index requires complicated calculations and long term maintenance, what do you think you can achieve by arguing for this level of greater transparency?

FD: We have this industry that is not providing investors with sufficient information on methodology or index composition. Prior to investing, investors should be in a position to verify the integrity of the track record, measure the risks and estimate the ease and costs of replication, and of course assess relevance and suitability with respect to their specific needs and constraints. You can’t do this without transparency, without being able to see what there is in the index and how index components are selected and weighted. Even for simple analyses on matters including concentration of stocks, turnover, liquidity and so on, you need the evolution of the index composition over time.

Along with other academics, we have documented that cap weighted indices don’t correspond to modern investment theory. The indexing space has evolved and smart betas have the potential of democratising 60 years of advances in finance, but their distinctive risks need addressing.

IU: Index companies offer a level of service that investors pay for. Wouldn’t providing the data for free challenge their intellectual property?

FD: We are opposed to this idea that if index providers give investors the data and method it will cause dramatic fall in revenues. There are other ways to protect technology and the rights of index providers. Just because you have access to data does not mean you have the right to use it. They can also add patents to methodologies.

There are natural protections for index providers. Products, which use indexes for investing, such as ETFs, choose the index by the brand of index and the way it is constructed, the way it is managed and so on. Just because the methodology is on show does not mean this will change. We believe that the product providers will continue to choose the same index providers. There is much more to the index business model than IP.

IU: What is the argument around intellectual property?

FD: The argument around intellectual property is that by not disclosing the methodology or sharing the data, it is easier to protect the IP and eventually foster more innovation. This is just an easy way out. There are other ways to protect the rights of index providers. There are legal (for example, patents) as well as contractual tools (for example, licenses) to defend index providers against the unauthorised use of their methodologies and data.

Disclosing the methodology or providing historical data for purposes of research and evaluation should not be equated with destroying IP rights and the business model of index providers—there remains multiple other usages to charge historical data for and multiple other sources of revenues, for example remember that live replication requires live data and value-added services.

The brand also offers “natural protection”: investors have demonstrated their readiness to pay significant premia for brands; challenges to established brands have remained limited. Just because the methodology is on show does not mean this will change: when an investor licenses the Russell 1000 Index or the S&P 500 Equal Weight Index for replication, they are not doing so to access the underlying methodologies. Familiar brands are here to stay.

IU: Other than already discussed, what other issues do you feel still surround index transparency an what duty do regulators have?

FD: We have to question why, if the index providers are so comfortable with transparency, they have lobbied for IOSCO to shelve the idea of index replicability and adopt the lowest level of transparency possible, clarifying for the avoidance of doubt that disclosing “summary information and key features” would be sufficient for compliance with its principles.

The Index Industry Association (IIA) has told regulators that providing more granular information would be of no benefit to index users. We cannot subscribe to this point of view—this level of transparency is just not high enough for end-investors and it is a disservice to the industry. The backtracking of IOSCO on this issue is deplorable and we call on European lawmakers to avoid walking down the same path and instead uphold the high standards of investor-protection and fair-competition set by ESMA.

I see two main sources in the current regulatory interest in indices: one that evolved from the scrutiny applied to ETPs when regulators were invited to review the financial stability implications of fast-growing and evolving segments of the financial industry and another that sprung from the integrity issues with the oil price benchmarks and the “IBOR” scandals.

IU: What regulatory solutions do you support?

FD: As to the appropriate level of transparency, we hail the ESMA Guidelines as the global benchmark for index transparency. The ESMA Guidelines restrict the eligibility of financial indices for UCITS to indices that provide sufficient transparency, on a complimentary basis, for independent historical replication. This is the minimum level of transparency allowing investors to do their diligence and it fully preserves the index industry’s ability to charge, inter alia, for live replication.

If we add to this the guarantee of non-discriminatory access for all and the freedom to perform and publish research and analyses, then you have a model that both preserves the economic viability of index providers and is informationally efficient. Together, these two conditions are supportive of sustainable growth and further innovation in the industry.

IU: You now have your own Smart Beta platform, is this not just a convenient argument for yourselves?

FD: Our interest in transparency is rooted in our mission, which is to conduct academic research on issues of key relevance to long-term investors and to highlight its implications and applications to practitioners, and in our areas of specialisation: asset allocation and risk management. We have been doing research on indices and benchmarking for over twelve years: explaining the importance of benchmarks, looking at the quality of indices, promoting better indexing practices as well as new usages of indices, questioning innovations but also developing and publishing new index methodologies in various asset classes; all with a view to improving market efficiency and investor welfare.

In the process, we have developed an appreciation for the limitations imposed on modern risk and investment management by opacity, which has prompted us to call on providers to provide the necessary transparency for investors to perform their due diligence and researchers to add to the body of knowledge.

IU: Your own index data is free then?

FD: The idea behind the ERI Scientific Beta initiative goes beyond providing full transparency on smart beta. The platform enables investors to create their own benchmark by making informed choices among a wide range of options at the universe selection and weighting stages of the index construction process, whilst controlling the risks of these choices.

We call this approach Smart Beta 2.0 in opposition to the traditional approach that sees the index provider make all the decisions for the investor and package them in a product. The platform does not promote a specific strategy but instead allows investors to build or select indices that are representative of the most popular forms of academically-validated smart beta.

The Smart Beta 2.0 approach allows for the control of systematic risk factors (which can be managed through stock selection decisions or factor constraints); of strategy-specific risk (which can be managed by diversifying across strategies); and of relative performance risk with respect to traditional market cap-weighted benchmarks (which can be managed through tracking error control).