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Remember the risks with new forms of indexing
Craig Hurt
There is a bit of a backlash against indexing through the use of smart beta strategies by big super funds and ETFs by individual investors, as well there should be. However, before we throw the baby out with the bathwater, investors should consider improving on the latest batch of quant-driven semi-passive options.
AXA Investment Managers, which looks after Rosenberg Equities in Australia, has distributed a short paper, coinciding after a recent publicised visit to Australia by several key executives, which includes the firm’s answers to commonly asked questions on the risks associated with smart-beta investing.
The big risk, of course, is for the investor to get caught in a bubble and lose, fairly quickly, a significant portion of his or her net worth. Remember 1999 and 2007.
Craig Hurt, AXA IM’s Australian head, says: “A number of smart-beta solutions have been successful at lowering risk while also generating excess return over market-cap indices by targeting exposure to risk premia such as low volatility. But are there any hidden risks investors are exposed to when investing in a simple low volatility approach?”
The US-based global quant manager suggests consideration of the following five points in this paper from Rosenberg Equities. The firm says:
> There are certain ‘extreme’ risks present in the equity market which add volatility without earning a sufficient return. In order to identify and hence systematically avoid exposure to these risks, a granular fundamental insight is required.
> Holding the most expensive stocks is a source of extreme risk that investors may not be rewarded for taking.
> While we believe that exposure to Value can improve returns over the long term, our analysis also reveals that extremely cheap stocks can be another source of extreme risk that investors may not be compensated for taking.
> Because a naïve low-volatility approach does not consider valuation, low volatility investors are left exposed to these ‘extreme’ risks. We found the most expensive low beta names are trading on Price-to-Book multiple of 8.1x, compared to 2.5x for the median.
> A smart-beta investor can improve upon the risk and return outcome offered by a naïve low volatility risk premia exposure by building in controls to systematically avoid the extremely expensive stocks and extremely cheap stocks (on a book-value basis, at least).
