Institutional investors tied to tight tracking-error targets don’t have to break up with the benchmark to boost risk-adjusted returns, according to Scientific Beta.
But the specialist index provider argues benchmark-constrained investors need to carefully spend “every basis point of active risk” when straying off strict cap-weighted limits.
In a recent analysis, Scientific Beta found investors can capture well-known factor benefits such as value, momentum and size even under a 1 per cent tracking-error mandate.
The study shows an ‘enhanced passive’ developed market index squeezed out higher returns compared to a pure cap-weighted counterpart over a 20-year period without blowing the risk budget.
“Over the 20 years to 31 March 2026, the Enhanced Passive profile generated an annualised return of 9.16%, compared with 8.49% for the cap-weighted benchmark,” a Scientific Beta release says. “This represented an annualised relative return of 0.67%, with realised tracking error of 1.06% and an information ratio of 0.63.”
Designed to keep portfolio beta close to one while tilting to various factors, the enhanced passive index volatility was also slightly lower than the vanilla benchmark over the 20-year stretch.
“Perhaps more importantly for a benchmark-conscious investor, the results were not confined to one market environment,” the release notes. “Relative returns were positive in both rising and falling markets, while exposure to each of the five targeted factors remained positive.”
An exercise using the Scientific Beta ‘semi-active’ index for investors with a higher risk tolerance in the 2-4 per cent tracking-error range, found similar long-term benefits for a controlled deviation from market cap limits.
Susan Rodgers, Scientific Beta APAC head of business development, said in a statement: “We don’t see a larger active risk budget as a licence to take more speculative bets. The same discipline should apply whether an investor has 1% or 4% of tracking error — the aim is to make every basis point of active risk work as hard as possible.”
In July this year, European indexer ISS STOXX, a Deutsche Börse Group subsidiary, acquired Scientific Beta from the Singapore Stock Exchange (SGX).
Gary Retelny, ISS STOXX chief, said at the time that the deal “strengthens our ability to meet the growing demand for systematic, rules-based strategies that are undergirded by world-class research, for institutional investors across the globe.”
Scientific Beta was founded within the French investment educational outfit, EDHEC-Risk Institute, in 2012. SGX paid €186 million to take a 93 per cent piece of Scientific Beta in 2020.