Mind the Gap: On the Importance of Understanding and Controlling Market Risk in Smart Beta Strategies

Abstract

The authors argue that more attention should be paid to market exposure when conducting analyses of smart beta strategies. They point out that most research proposing new multifactor investment methodologies essentially ignores exposure to the market factor, which is the most consensual among all factors and often the most influential factor for a strategy. Overlooking the dominant factor is in stark contrast to the objective of factor investing, which aims to identify and manage the main drivers of risk and return. The authors document that different levels of market beta indeed have a strong impact on the performance and risk of smart beta strategies. The impact is visible in terms of long-term returns, volatility, and the dependence of performance on market conditions. Such effects need to be properly documented to allow investors to make explicit choices in their risk exposures. In the event of a mismatch with investor preferences, it is possible to adjust multifactor strategies to respect target levels of market beta.