Scientific Beta white paper examines crowding risk of smart beta strategies


Press Release - Boston, London, Nice, Paris, Singapore, Tokyo, May 12, 2020

Scientific Beta white paper examines crowding risk of smart beta strategies

Thinking about the economic rationale behind a specific premium should provide ample answers to allay crowding concerns

In a new white paper entitled "Crowding Risk in Smart Beta Strategies," Scientific Beta's researchers have failed to find evidence that smart beta strategies have been adversely affected by a crowding effect.

As smart beta strategies gain in popularity, there are concerns that flows into these strategies will ultimately cancel out their benefits. However, such claims are rarely based on solid empirical evidence. The academic literature has not only documented risk premia for the standard factors but has also provided theoretical explanations for persistence, notably if factors are compensation for taking on additional types of risk. Moreover, precautions against crowding risks can be taken by proper implementation of factor investing and smart beta indices. In particular, the best precaution against crowding seems to be diversification.

It is possible that smart beta and factor strategies can be subject to adverse effects due to a wide following but one can only conclude that this is the case if there is evidence for it. Losses in a given strategy, meanwhile, are not evidence of crowding. Periodic underperformance may be due to normal fluctuations in prices.

Commenting on the paper, Professor Noël Amenc, CEO of Scientific Beta and a co-author of the paper, said, "Claiming that there must be crowding in a factor because it suffers from losses completely ignores the nature of risk premia. A risk premium corresponds to a higher average return that is the compensation for taking on additional risk. Therefore, losses to any factor strategy over any particular period do not imply that the long-term premium has disappeared because of "crowding". Such losses may simply suggest that the reward for holding the factor comes with associated risk. In addition, not only our work, but also work from other researchers shows that factor premia do not disappear when the research that justifies the premia is published."

The Scientific Beta white paper can be accessed through the link below:

Crowding Risk in Smart Beta Strategies, April 2020, Scientific Beta Publication

As part of its policy of transferring know-how to the industry, EDHEC-Risk Institute has set up Scientific Beta. 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.
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