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

February 23, 2016

Just like in the factor zoo, the cumulative performance of each smart beta strategy largely co-moves with changes in valuation. We can make several important observations. For equal weight and Fundamental Index, a significant wedge between performance and relative valuation level develops over time. For the maximum diversification and risk efficient strategies, the return due to changes in valuation is significantly more volatile than for the other strategies. The volatility is being driven by substantial changes in portfolio composition. As a result, changes in valuation will be a less informative metric for these two strategies than for others; further supporting this explanation is the low correlation (−0.15) of maximum diversification's valuation level with its subsequent performance. Low volatility's story is similar to the one told by the low beta factor: changing valuations explain much of the past performance. Quality weaves an interesting tale as well. Performance was less than impressive over the years 1973 to 1990 as valuations started the period quite high, but improved markedly as valuations bottomed out in the early 1990s and began to climb.

The scatterplots in Figure 3 show, quite in the spirit of Arnott and Bernstein (2002), that the valuation levels for smart betas are as informative of future performance for the strategies as they are for the markets in general. As noted earlier, we will review current valuations (red dot in figure scatterplots) in a later article, but this quick preview suggests many smart beta strategies and factors are more expensive than historical norms. We should beware the alpha mirage inherent in mean-reverting valuations!

Valuation-Adjusted Performance: A Cautionary Tale. Let's compare the excess returns of the six factor-tilt strategies and the six smart beta strategies. We look at the latest 10 years (2005 Q4–2015 Q3) and almost 49 years (1967–2015 Q3). Many investors believe 10 years is long enough to assess a strategy's ability to deliver future performance. After all, active manager track records are often considered relevant after just 5 years. Some even argue recent performance—the past 10 or 20 years—is most representative of future performance because markets are very different today compared to generations past. We strenuously disagree. Our parable, "The New Paradigm of 1999," demonstrates even a half-century (two generations!) is not necessarily long enough to draw the correct conclusions.

To improve outcomes, investors should seek more data, ideally covering a wide range of market environments, fads, and shifting investor preferences. Sadly, commercial options are not helpful in this regard. A quick survey of two of the larger factor index providers shows average factor indices have track records between 14 and 17 years.20 One substitute for "more data" is to at least subtract the return that comes from changes in relative valuation, so investors won't fall prey to the seduction of performance chasing and don't mistake a relative-performance bull market (in a stock, style, factor, sector, asset class, or strategy) for alpha.21

In Table 1 we report the return decomposition for each factor and smart beta strategy, showing how much of the performance comes from changes in valuation. We provide two estimates of valuation-adjusted performance: 1) performance net of valuation change, which is a simple difference between return and the concurrent change in valuation; and 2) adjusted performance net of valuation change, a more conservative estimate, which we calculate by subtracting only a regression-based fraction of the changes in valuation.22


Research Affiliates

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Research Affiliates

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