This is the first of a series on the future of smart beta.
- Factor returns, net of changes in valuation levels, are much lower than recent performance suggests.
- Value-add can be structural, and thus reliably repeatable, or situational—a product of rising valuations—likely neither sustainable nor repeatable.
- Many investors are performance chasers who in pushing prices higher create valuation levels that inflate past performance, reduce potential future performance, and amplify the risk of mean reversion to historical valuation norms.
- We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies.
Because active equity management has largely failed to deliver on investors' expectations,1 investors have acquired a notable appetite for any ideas that seem likely to boost returns. In this environment, impressive past results for so-called smart beta strategies, even if only on paper, are attracting enormous inflows. Investors often choose these strategies, as they previously chose their active managers, based on recent performance. If the strong performance comes from structural alpha, terrific! If the performance is due to the strategy becoming more and more expensive relative to the market, watch out!
Performance chasing, the root cause of many investors' travails, has three inextricably linked components. Rising valuation levels of a stock, sector, asset class, or strategy inflate past performance and create an illusion of superiority. At the same time, rising valuations reduce the future return prospects of that stock, sector, asset class, or strategy, even if the new valuation levels hold. Finally, the higher valuations create an added risk of mean reversion to historical valuation norms.
Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive. Is the financial engineering community at risk of encouraging performance chasing, under the rubric of smart beta? If so, then smart beta is, well, not very smart.
Are we being alarmist? We don't believe so. If anything, we think it's reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies. This provocative statement—especially by one of the original smart beta practitioners—requires careful documentation. In this article we examine the impact of rising valuations on many popular smart beta categories.
A Risk Premium Parable: The 'New Paradigm' Of 1999
A quick look back to 1999 is instructive. Over the second-half of the 20th century, the S&P 500 Index produced a 13.5% return (an annualized real return of 9.2%) and 10-year Treasuries a 5.7% return (an annualized real return of 1.6%). During this 50-year period, stocks delivered an excess return relative to bonds, let alone cash, of almost 7.5% a year!2 The investing industry embraced these historical returns as gospel in setting future return expectations—at the top of the tech bubble, pension fund discount rates and return assumptions were the highest ever, before or since, for stocks and balanced portfolios. In the late 1990s, many proclaimed a "new paradigm": profits were no longer needed, and equity valuations could rise relentlessly. Remember "Dow 36,000"? We're still waiting.
The problem with these forecasts is that fully 4.1% of the annualized 50-year (1950–1999) stock market return—nearly half of the real return!—came from rising valuations as the dividend yield tumbled from 8% to 1.2%. The Shiller PE ratio more than quadrupled from the post-war doldrums of 10.5x to a record 44x.3 Reciprocally, as bond yields tripled over the same period, from 1.9% to 6.6%, real bond returns were trimmed by an average 0.7% a year, creating modest capital losses atop skinny real yields. If we subtract nonrecurring capital gains (for stocks) and losses (for bonds) from market returns, the adjusted historical excess return falls to 2.5%.4,5 Thus, over this stupendous half-century for stocks, the true equity premium was 2.5%. The 7.5% gap between stocks and bonds was an unsustainable change in relative values!