Esma to step up smart beta scrutiny

Esma has followed the Financial Industry Regulatory Authority in signalling its intention to scrutinise backtesting and replication of smart beta index products more closely in 2015

Esma: smart beta under scrutiny

The European Securities and Markets Authority (Esma) is preparing to intensify its scrutiny of smart beta index products this year, a senior official at the watchdog has indicated, with a particular focus on the replicability behind the methodologies of products targeted at end-investors.

In an interview with Risk.net, Patrick Armstrong, Paris-based senior officer for financial innovation at Esma, says the regulator will focus on the methodologies firms use when constructing alternative indexes – commonly referred to as smart beta indexes.

"We would like to see a greater degree of transparency around the methodologies employed in creating those indexes, as well as the ability of the investor to reproduce any type of simulated track record that the alternative index provider or smart beta provider is publishing," Armstrong told Risk.net.

Esma will join a growing number of regulators training their sights on index provision. While it is not currently planning on issuing specific guidelines or a best practices document on smart beta risks and transparency, the topic will be under ongoing discussion at its financial innovations committee meetings in 2015, says Armstrong. The watchdog will also publish a paper on smart beta in its next quarterly trends, risks and vulnerabilities report, due to be published in March.

The news is likely to be greeted warily by issuers and index providers, many of whom argue privately that the industry is already required to go to considerable lengths when assessing the appropriateness of such products for end-investors before the point of sale.

Investors seeking to minimise one type of risk may inadvertently be exposing themselves to unintended and material sector or factor exposure

One example where Esma believes transparency could be improved is in the use of backtests in smart beta prospectuses, says Armstrong.

"Among the most popular alternative index strategies is typically some sort of minimum-volatility process," he says. "What does that mean from a risk standpoint if the objective is to minimise volatility? In the process of minimising volatility, the investor is likely to be heavily exposed to value-like sectors. We want to ensure that the investor, when seeking to minimise one type of risk, realises that they may inadvertently be exposing themselves to unintended and material sector or factor exposure."

In Esma's most recent trends, risks and vulnerabilities report, published in September, alternatively weighted indexes were briefly mentioned in the context of exchange-traded funds. Armstrong acknowledged the products' popularity with investors, which has increased dramatically post-crisis as many have sought an alternative to active strategies that generally charge significantly higher fees. In contrast to traditional cap-weighted indexes, smart beta products use a rules-based, systematic weighting that tracks factors such as low volatility or momentum with the aim of delivering superior, diversified returns.

"In general, they're a very interesting product. We're focused on innovation and it's definitely one of the most prominent products to have arrived in recent years," says Armstrong, adding that Europe especially has seen strong growth in the form of an exchange-traded product wrapper as the favoured market vehicle for placing smart beta strategies.

Speaking at the Structured Products Europe conference in November, Armstrong said the regulator considered it good practice for firms to backtest their retail structured products prior to launch in addition to carrying out stress tests, but not necessarily to make those details public.

With smart beta, however, Armstrong says Esma is looking at backtesting in a different way. While there was no specific index that brought the attention to a head, a combination of warnings from academics, national competent authorities and the industry raised red flags for Esma, he adds.