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

February 23, 2016

A second lesson we take from our analysis is that as the market evolves, the "normal" valuation level for a strategy may change. A good example is provided by low beta investing, a factor only recently gaining popularity, and the only one of the six we analyze lacking a statistically significant relationship. Although the strategy offers a market-like return with lower risk, it has high tracking error risk vis-à-vis the market. The virtually guaranteed result is prolonged periods of substantial underperformance, especially as in the near-continuous bull market of the 1990s.17 Over the last 15 years, however, two bear markets and the accompanying muted cumulative returns have forced investors to reconsider. Large asset flows into low beta products are now driving valuation levels far above their historical norms. Low beta's end-point in relative valuation is near an all-time peak, meaning the historical link between relative valuation levels and returns will seem weak, even if it's not (since these recent high valuations have not yet had the chance to mean revert).

The scatterplots in Figure 2 compare relative valuation and subsequent relative performance for each of the factor portfolios. This relationship is the flip side of the relative and valuation-adjusted performance relationship. If a strong link exists between relative valuation and cumulative relative performance (graphs figure-left), the market's chasing of or fleeing from stocks with a particular factor exposure creates much of the factor's return. The same run-up in relative valuation that boosts past relative performance—the typical driver of asset management choices—just as assuredly sets the stage for subsequent lower returns as a consequence of mean reversion. The statistical significance of most of the factors confirms the effect is real—so much for the random walk!

The red dot in the scatterplots indicates the current valuation level of each factor. We will review current valuation levels—making some interesting and surprising revelations—in a later article. In the meantime, this peek into current valuations shows that some of the most popular factors are trading at expensive relative valuations compared with their own historical norms.

Relative Valuation in Smart Beta Portfolios. We examine six smart beta portfolios to determine if they exhibit the same pattern. Most of the six conform to our definition of smart beta, which is much narrower than the market's. We subscribe to a core definition—the strategy must sever the link between the price of a stock and its weight in the portfolio—and a weaker requirement: a smart beta strategy should include most of the advantages of conventional indexing, such as low turnover, broad market representation, liquidity, capacity, transparency, ease of testing, low fees, and so forth (Arnott and Kose, 2014). Our analysis, described in Figure 3, includes six strategies: equal weight (the 1,000 largest-cap stocks, equally weighted), Fundamental Index™, risk efficient (popularized by EDHEC), maximum diversification (popularized by TOBAM), low volatility (based on the S&P methodology), and quality (based on the MSCI Quality Index methodology, which uses profitability, leverage, and earnings volatility as a definition of quality).18 Of these, only the quality strategy anchors on cap weighting and would not qualify as smart beta under our narrow definition. For each, we use the published methodology, reconstituting and reweighting annually at year-end in a universe of the 1,000 largest market-cap stocks.19 (Click here for a full description of the simulation methodology.)


Research Affiliates

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Research Affiliates

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Research Affiliates

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Research Affiliates

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Research Affiliates

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Research Affiliates

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