Arnott and Bernstein (2002, p. 64) observe that "the investment management industry thrives on the expedient of forecasting the future by extrapolating the past." But, we must make every effort to avoid being duped by historical returns. We can accomplish this by netting out the effect of changing valuations on past returns, which arguably gives us a more reliable historical "normal" expected return. Then, we need to go one step further. We should also adjust our expectations to allow for the possibility of mean reversion to historical norms for relative valuation.
The steady backtests rolling out of smart beta proliferators indicate a 2–3% excess return can be earned from a variety of "alpha sources." Normal returns are being extrapolated based solely on past performance, not at the equity asset class level but within it. But this reassuring message has two primary and interrelated flaws.
First, many of these alpha claims are based on a 10- to 15-year backtest that won't cover more than a couple of market cycles. Second, such a short time span is very vulnerable to distortion from changing valuations. Our analysis shows that valuation has been a large driver of smart beta returns over the short and even long term. How much can we reasonably expect in future returns from these factors and strategies, net of valuation change? For some strategies perhaps a great deal, and for others, not much.
Today, only the value category shows some degree of relative cheapness, precisely because its recent performance has been weak! Generally speaking, normal factor returns, net of changes in valuation levels, are much lower than recent returns suggest. Investors entering the space should adjust their expectations accordingly.
Academe would do well to explore how much of the success of their favorite factors (and the dozens of new factors published each year) is coming from rising relative valuation levels. If rising valuation levels account for most of a factor's historical excess return, that excess return may not be sustainable in the future; indeed our evidence suggests that mean reversion could wreak havoc in the world of smart beta. Many practitioners and their clients will not feel particularly "smart" if this forecast comes to pass.
In the next two articles of this series, we will discuss which factor-tilt and smart beta strategies are over- or undervalued relative to historical norms. Some may be priced to deliver negative future alpha, not positive! And we will objectively test the comparative efficacy of performance chasing in the factor zoo (i.e., favoring the factor tilts and smart beta strategies with the best recent performance) against investing in strategies with abnormally poor recent performance. The results are eye-opening to say the least.