Research Affiliates: How Can ‘Smart Beta’ Go Horribly Wrong?

February 23, 2016

Relative Valuation Levels In The 'Factor Zoo'

Relative valuation affects factor returns throughout the factor zoo.14 We find that the efficacy of a factor-based strategy or a factor tilt (included by many under the smart beta umbrella) is strongly linked to changes in relative valuation, that is, whether the strategy is in vogue (becoming more richly priced) or out of favor (becoming cheaper).

How do most investors assess whether these factors and strategies work? The same way they figure out the effectiveness of conventional active managers: past performance! How do academics determine which factors can get them published? Again, past performance! What do most investors and academics miss? The effects of changing relative valuation levels, of course!

Relative Valuation in Factor Portfolios. We begin our analysis by examining the relative performance and relative valuations for six sample factor portfolios: value, positive momentum, small cap, illiquid, low beta, and high gross profitability. As illustrated in Figure 2, performance appears closely matched to changes in relative valuation levels for four of the six factors, with the exception of momentum and perhaps low beta (as in Figure 1, the black line tracks factor performance and the red line tracks P/B valuation level for the long sides of the portfolios relative to the short sides). Momentum and low beta share the characteristic of rapid turnover, which means that the changes in valuation will change with portfolio changes, rather than from the stocks becoming more or less expensive, relative to the market. The momentum of a stock has essentially no correlation from one year to the next; beta has a substantial estimation error, and thus can change rapidly for both legitimate and spurious reasons.15


Research Affiliates

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Research Affiliates

For a larger view, please click on the image above.


Research Affiliates

For a larger view, please click on the image above.


Research Affiliates

For a larger view, please click on the image above.


Research Affiliates

For a larger view, please click on the image above.


Research Affiliates

For a larger view, please click on the image above.

The positive momentum factor portfolio will usually trade at a premium because high momentum stocks have, by definition, risen in price. On rare occasions, when deep value stocks have turned sharply and are exhibiting positive momentum, the high momentum portfolio might even trade more cheaply than the low momentum portfolio. When stocks with positive momentum are cheaper relative to the market than their historical norms, the mere act of fading momentum can drive an individual stock out of the positive momentum portfolio before it enjoys any mean reversion in valuation. A lesson we can draw from this is the higher a strategy's turnover, the less informative are valuation changes in understanding the strategy's performance and predicting its future performance.

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