Over the last few years, we have witnessed the proliferation of smart-beta and factor-tilting strategies. These strategies can play an important role in portfolios but investors need to understand the nature of risk introduced by these strategies.
Our analysis of a range of smart beta strategies in the eVestment data-set shows that most smart-beta strategies have a very high level of systematic risk. Systematic risk in some smart beta strategies can be as high as 95 percent with the median of the sample around 80 percent. By definition, systemic risk cannot be diversified. Adding smart beta strategies to passive components or active strategies may actually amplify risk, not diversify.
A detailed decomposition of systematic risk into market, style and sector shows a very high level of variability between strategies. Sector risk in particular dominates the systematic risk component. This is an important source of risk for many smart beta portfolios particularly if valuation factor or adjustment is not robust. This is specifically critical for smart beta strategies (example low volatility strategies) that have captured enormous flows in the last few years.
Advancements in technology mean investors can measure and manage the risk levels across allocations into passive, smart-beta and highly active strategies. Appropriate factor-based optimisation process can help investors balance well between cost, risk types and alpha factors targeted by the composite.