In 2014, EDHEC Risk Institute researchers had shown in an article published in the Journal of Portfolio Management (Amenc, N., F. Goltz, A. Lodh and L. Martellini, Summer 2014, Towards Smart Equity Factor Indices: Harvesting Risk Premia without Taking Unrewarded Risks, Vol. 40, No. 4) that over the long term good diversification of the specific risk of factor indices led to much better risk-adjusted performance than the traditional approaches to constructing these indices.
In a new EDHEC Risk Institute working paper entitled "The Limitations of Factor Investing: Impact of the Volkswagen Scandal on Concentrated versus Diversified Factor Indices," Noël Amenc, Professor of Finance, EDHEC Risk Institute and CEO, ERI Scientific Beta, and his co-authors Sivagaminathan Sivasubramanian, Quantitative Analyst, ERI Scientific Beta, and Jakub Ulahel, Quantitative Research Analyst, ERI Scientific Beta, have shown that in the short term this good diversification enabled one to cope with the consequences of risks that affected a stock or a sector of activity. As such, the Scientific Beta Extended Europe Multi-Beta Multi-Strategy EW index outperformed the Stoxx Europe 600 index by 18% in the week from September 18 to September 25, 2015. Over the same period, a score-weighted index allocated to the same risk factors, but with a construction method that led to excessive concentration, and therefore to poor diversification of the specific risk, underperformed the Stoxx Europe 600 index by 3%.
In their concern to maximise factor exposures, multi-factor index providers have favoured concentration of the indices to the detriment of their diversification. Even though the excessive concentration of cap-weighted indices was one of the motivations for creating smart beta indices, solely taking the factor dimension into account ultimately leads to the indices exposing investors to considerable specific risks. We observe for example that the J.P. Morgan Europe Multi-Factor index was very strongly exposed to the risk of the Volkswagen AG stock, as was the MSCI Europe Diversified Multi Factor index. As such, these indices respectively contained almost 1.5 and more than 2 times more Volkswagen AG stock than the Stoxx Europe 600, and almost 10 times and 16 times more Volkswagen AG stock than the Scientific Beta Extended Europe Multi-Beta Multi-Strategy EW index.
Ultimately, and going beyond the stocks, the excessive concentration of these indices meant that they considerably underperformed the SciBeta Extended Europe Multi-Beta Multi-Strategy EW index, with -30% for the MSCI Europe Diversified Multi Factor index and -66% for the J.P. Morgan Europe Multi-Factor index over the period from August 31, 2015, to September 30, 2015.
With the Volkswagen scandal, the EDHEC Risk Institute and ERI Scientific Beta research teams wish to stress that the robustness of multi-factor indices depends on both the balance of factor exposures and good diversification of specific risks. It is only on this double condition that an index can be qualified as smart.
A copy of "The Limitations of Factor Investing: Impact of the Volkswagen Scandal on Concentrated versus Diversified Factor Indices" can be downloaded via the following link:
ERI Working Paper Limitations of Factor Investing
ERI Scientific Beta, 1 George Street, #07-02, Singapore 049145. For further information, please contact: Séverine Cibelly, Tel.: +33 493 187 863, E-mail: severine.cibelly@scientificbeta.com, Web: www.scientificbeta.com.
