Sector risk is the main explanation for the underperformance of many factor strategies compared to their market cap-weighted benchmarks over the last three years, according to ERI Scientific Beta, a smart beta index provider.

ERI Scientific Beta has found that sector biases within many smart indices has been the main source of underperformance versus cap-weighted benchmarks over the past three years.

In a recent research paper, entitled “Managing Sector Risk in Factor Investing,” the index provider focused on the implicit sector risk taken by factor indices and analysed the implications for their short- and long-term risk-adjusted performance.

The firm, which is affiliated to EDHEC-Risk Institute, used a comparison between standard factor indices and their sector-neutral counterparts.

The authors of the report found that sector-neutrality adds value in terms of reducing tracking error and short-term underperformance with respect to the reference cap-weighted index.

De facto, a large share of the underperformance attributed to factors in recent years actually relates to sector biases.

Sector-neutrality nonetheless comes with costs in the form of higher volatility and lower factor intensity.

The researchers conclude that the choice of using the sector-risk-control option is a trade-off between investors’ aversion to short-term risks generated by sector risk and their willingness to harvest factor risk premia in the most efficient way, to achieve the highest risk-adjusted performance over the long run.

Investors are advised to seek an investment framework whereby they are able to make explicit choices, not just on targeted factors but also on additional risk control options.