Over the last 10 years, of the six factors, gross profitability (the quality definition most popular in current academic research) had the best performance, while value had the worst. We also find that essentially all of the outperformance for profitability is due to rising valuations. When we subtract the returns associated with the rising popularity, and therefore rising relative valuation, of high-profit companies versus low-profit companies, the gross profitability factor loses more than 90% of its historical efficacy, delivering 10-year performance net of valuation change of just 0.39%. The more conservative regression-based performance estimate trims excess return by two-thirds, from 4.54% to a much less spectacular 1.57%.
Rising valuations also provided a substantial tailwind for momentum and illiquidity over the last decade. This means gross profitability, momentum, and illiquidity are all considerably more expensive today than they were 10 years ago. Over this same period, we see value has floundered because it was out of favor and becoming ever cheaper!
A look at the full-sample period shows, first, that all of the factors had positive performance. This should not be surprising as the popular factors were identified and published because they had high past performance. Factors and strategies with marginal or insignificant long-term performance will routinely be discarded. Second, the two factors with the lowest overall full-sample performance are gross profitability and low beta, despite their brilliant performance record during the past decade.
Even over nearly a half-century, a shocking portion of the return for several factors comes from rising relative-valuation levels. Net of rising valuation, the value added by low beta disappears entirely or is reduced by a third, considering the more conservative regression-adjusted estimate; the same holds true for gross profitability. Should investors really expect to be rewarded for profitability or quality? Shouldn't we accept a lower return for safer assets? Some of the strategies, for example, low beta, may still be an attractive investment, but for their risk-reducing characteristics not for the alpha they have historically provided, net of their rising popularity and relative valuation. These data suggest that common sense prevails: lower risk, higher quality, and safety have all earned a strong premium only as a consequence of becoming more expensive! Will this upward adjustment in relative valuation prove permanent? Figure 2 suggests otherwise. But even if it is, we cannot rely on rising valuations to continue to create an illusion of alpha.24
The six smart beta strategies all delivered positive excess returns over both the 10-year period and the full-sample period. But, net of the effect of changing valuations, results are mixed. The strategies hurt most by the declining valuations over the last decade are risk efficient and Fundamental Index. But despite valuations moving in an adverse direction, both strategies were able to outperform in the last 10-year period.25
The low vol, maximum diversification, and quality strategies all experienced a large performance tailwind from rising relative valuations. Over the last decade, the low vol strategy, for example, delivered 0.82% a year in return. Because the strategy became significantly more expensive over the period, the return from changing valuations was 1.65% a year. Thus, more than 100% of its return came from expanding valuations! Over the full-sample period, maximum diversification generated performance of 1.59% a year; without the 1.62% a year it earned from rising valuations, performance would have been negative. Our analysis of past performance accompanied by rising valuations does not make a very convincing case that similar performance can be repeated in the future.
In the last decade, quality generated the best performance of all smart betas at 2.37% a year, helped by rising valuations. This result is a backtest, and the best way to validate a backtest is to use out-of-sample data. During the 39-year period 1967–2005, quality delivered a −0.14% annualized return. Not surprisingly, in the longer 49-year sample, quality had the worst performance of all smart betas at 0.37% a year. Interestingly, unlike the gross profitability factor for which close to 100% of both 10-year and full-sample returns is attributable to rising valuations, the 0.37% a year return for the quality factor did not come from rising valuations. This highlights another problem with quality investing: quality portfolios can be quite sensitive to the definition being used. A portfolio formed on gross profitability can be very different from a portfolio formed on quality, which is based on profitability, leverage, and earnings volatility.