New Scientific Beta publication highlights the importance of sector risk in factor investing and the importance of deciding whether to control it or not
Sector risk is the main explanation, with the market beta bias, for the underperformance of many factor strategies in the last three year
In a new publication entitled "Managing Sector Risk in Factor Investing," ERI Scientific Beta researchers focus on the implicit sector risk taken by smart factor indices and analyse the implications for their short- and long-term risk-adjusted performance.
Focusing on a comparison between standard smart factor indices and their sector-neutral counterparts, the authors highlight several key findings:
- Sector-neutrality adds value in terms of reducing tracking error and short-term underperformance with respect to the reference cap-weighted index. De facto, a large share of the underperformance attributed to factors in recent years actually relates to sector biases.
- Sector-neutrality nonetheless comes with costs in the form of higher volatility and lower factor intensity. Investors who wish to maximise the benefits of factor investing over the long term should therefore question the idea of protecting the short term through sector neutrality.
- It is precisely the objective of Scientific Beta’s Smart Beta 2.0 framework to allow investors to make such explicit choices, not just on the targeted factors but also on additional risk control options
The authors conclude that the choice of using the sector-risk-control option is a trade-off between investors’ aversion to short-term risks generated by sector risk and their willingness to harvest factor risk premia in the most efficient way, to achieve the highest risk-adjusted performance over the long run.
The white paper can be downloaded through the following link:
ERI Scientific Beta Publication Managing Sector Risk in Factor Investing
As part of its policy of transferring know-how to the industry, EDHEC-Risk Institute has set up ERI Scientific Beta. ERI Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in smart beta design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency of both the methods and the associated risks.
ERI Scientific Beta, 1 George Street, #15-02, Singapore 049145. For further information, please contact: contact@scientificbeta.com, Web: www.scientificbeta.com.
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