'How Can "Smart Beta" Go Horribly Wrong?'--Research Affiliates

From Rob Arnott and crew:

This is the first of a series on the future of smart beta. 

Key Points

1. Factor returns, net of changes in valuation levels, are much lower than recent performance suggests.

2. Value-add can be structural, and thus reliably repeatable, or situational—a product of rising valuations—likely neither sustainable nor repeatable. 

3. Many investors are performance chasers who in pushing prices higher create valuation levels that inflate past performance, reduce potential future performance, and amplify the risk of mean reversion to historical valuation norms. 

4. We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies. 

Because active equity management has largely failed to deliver on investors’ expectations,¹ investors have acquired a notable appetite for any ideas that seem likely to boost returns. In this environment, impressive past results for so-called smart beta strategies, even if only on paper, are attracting enormous inflows. Investors often choose these strategies, as they previously chose their active managers, based on recent performance. If the strong performance comes from structural alpha, terrific! If the performance is due to the strategy becoming more and more expensive relative to the market, watch out! 

Performance chasing, the root cause of many investors’ travails, has three inextricably linked components. Rising valuation levels of a stock, sector, asset class, or strategy inflate past performance and create an illusion of superiority. At the same time, rising valuations reduce the future return prospects of that stock, sector, asset class, or strategy, even if the new valuation levels hold. Finally, the higher valuations create an added risk of mean reversion to historical valuation norms. 

Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive. Is the financial engineering community at risk of encouraging performance chasing, under the rubric of smart beta? If so, then smart beta is, well, not very smart. 

Are we being alarmist? We don’t believe so. If anything, we think it’s reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies. This provocative statement—especially by one of the original smart beta practitioners—requires careful documentation. In this article we examine the impact of rising valuations on many popular smart beta categories. 

A Risk Premium Parable: The “New Paradigm” of 1999

A quick look back to 1999 is instructive. Over the second-half of the 20^th century, the S&P 500 Index produced a 13.5% return (an annualized real return of 9.2%) and 10-year Treasuries a 5.7% return (an annualized real return of 1.6%). During this 50-year period, stocks delivered an excess return relative to bonds, let alone cash, of almost 7.5% a year!² The investing industry embraced these historical returns as gospel in setting future return expectations—at the top of the tech bubble, pension fund discount rates and return assumptions were the highest ever, before or since, for stocks and balanced portfolios. In the late 1990s, many proclaimed a “new paradigm”: profits were no longer needed, and equity valuations could rise relentlessly. Remember “Dow 36,000”? We’re still waiting.

The problem with these forecasts is that fully 4.1% of the annualized 50-year (1950–1999) stock market return—nearly half of the real return!—came from rising valuations as the dividend yield tumbled from 8% to 1.2%. The Shiller PE ratio more than quadrupled from the post-war doldrums of 10.5x to a record 44x.³ Reciprocally, as bond yields tripled over the same period, from 1.9% to 6.6%, real bond returns were trimmed by an average 0.7% a year, creating modest capital losses atop skinny real yields. If we subtract nonrecurring capital gains (for stocks) and losses (for bonds) from market returns, the adjusted historical excess return falls to 2.5%.^4,5 Thus, over this stupendous half-century for stocks, the true equity premium was 2.5%. The 7.5% gap between stocks and bonds was an unsustainable change in relative values!

The lofty past returns not only laid a foundation for lofty expectations, but also led to valuations that virtually guaranteed far lower future returns. As noted by Arnott and Bernstein (2002), investors in 1999 should not only have adjusted past returns to remove the impact of rising valuation levels, they should also have adjusted expectations to reflect the lowest-ever stock market yields and the above-average real bond yields.⁶ Investors could even have gone further, adjusting expectations to reflect the substantial likelihood of mean reversion. The higher equity valuations of today continue to translate into lower future returns than most investors expect. 

Nowadays, astute observers increasingly “get it,” at least to the point of subtracting valuation gains from past returns. A 2015 survey of investment consultant return expectations produced an average forward “long-term” (10-year) U.S. nominal equity return of 6.8% a year⁷; at the start of the century, return expectations over a similar horizon were in the double digits.^8,9 After 15 years and two punishing bear markets, investors are figuring out past returns need to be adjusted for the sometimes large impact of rising valuations, and expected returns need to be adjusted for the sometimes large impact of mean reversion. Even after the stellar bull market since early 2009, the annualized real return on U.S. stocks from 2000 to 2015 has averaged a scant 1.9% (not even matching the average dividend yield), while U.S. bonds have delivered an outsized real return of 3.6%. The “excess return” for stocks has been negative by a daunting 1.7% a year.

Our parable holds a relevant lesson for smart beta investors: a lengthy return history, even 50 years, does not guarantee a correct conclusion. Investors need to look under the hood to understand how a strategy or factor produced its alpha. We compare several popular strategies’ current valuations relative to history, and find that for many, much of the historical value-add—in some cases, all!—has come primarily from the “alpha mirage” of rising valuations. 

Academia is no less prone than the practitioner community to be a slave to past returns. Anomalies and factor returns tend to appear and then fade, depending on recent performance. Of course, no one will bother to publish a factor or a strategy that fails to add value historically; this encourages data mining and selection bias. In recent years, several hundred “factors” have been published, most showing statistically significant “alpha” and a path to higher future returns.¹⁰  

Value-add can be structural (hence, plausibly a source of future alpha) or situational (a consequence of rising enthusiasm for, and valuation of, the selected factor or strategy). Few, if any, of the research papers in support of newly identified factors make any effort to determine whether rising valuations contributed to the lofty historical returns. The unsurprising reality is that many of the new factors deliver alpha only because they’ve grown more expensive—absent rising relative valuations, there’s nothing left!

The Impact of Valuations on Returns: The Value Factor

The value effect was first identified in the late 1970s, notably by Basu (1977), in the aftermath of the Nifty Fifty bubble, a period when value stocks were becoming increasingly expensive, priced at an ever-skinnier discount relative to growth stocks. More recently, for the past eight years, value investing has been a disaster with the Russell 1000 Value Index underperforming the S&P 500 by 1.6% a year, and the Fama–French value factor in large-cap stocks returning −4.8% annually over the same period. But, the value effect is far from dead! In fact, it’s in its cheapest decile in history. In Figure 1 we compare the performance of the classic Fama–French value factor¹¹ (black line) with changes in its relative price-to-book (P/B) valuation levels (red line) from January 1967 to September 2015. When the black line is rising, value stocks are becoming more richly priced (i.e., the market is paying a shrinking premium for growth) and value is outperforming. Conversely, when the black line is falling, value stocks are almost always getting cheaper (i.e., the market is paying up for growth stocks) and value is underperforming. (Click Here for a full description of the simulation methodology.)...

...MUCH MORE

HT: The Financial Times whom I can't seem to link to.