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Arnott lays it on the line with smart beta
(pictured: Rob Arnott)
By Greg Bright
All super funds should subscribe, for free, to the Research Affiliates regular research notes, ‘Fundamentals’. Sure, they will try to steer you to their own smart-beta strategies. But Rob Arnott, the firm’s founder, sometimes even questions his own funds. Last week, he questioned “value” at current prices in smart beta.
In the second of a series of papers published last week, Arnott and others from the US-based quant shop which built its business on the Research Affiliates Fundamental Index (RAFI) in the 2000s say that with smart beta, as will other strategies, investors need to ask if the price is right. The first paper was called: “How Smart Beta Can go Horribly Wrong”.
The latest paper says over the past 50 years “almost all” smart beta strategies and eight factors studied show a negative relationship between starting valuation and subsequent five-year performance.
Today, valuations of many of the most popular factors and smart beta strategies are well above their historical norms, implying lower future returns, Arnott says.
“Product proliferation in factor investing and “smart beta” create two interconnected risks. First, few if any products will be introduced without having wonderful historical returns. In many cases, these returns are a consequence of rising valuations. Basically, in product creation our industry is data mining on past performance.
“This selection bias creates an illusion of high past alpha that often disappears when we subtract the effect of rising relative valuations. The alpha mirage creates implausible expectations for investors, who are disappointed when realized returns almost inevitably fall short, and they switch strategies, typically at a substantial cost.
“The second risk is far more dangerous: investing when relative valuations are at an extreme: a.k.a. performance chasing. Investing in overpriced strategies is value destroying. High past alpha can quickly become negative future alpha.
“Investors lock in their loss when they move on to the next strategy with wonderful past returns. Just like in selecting stocks, asset classes, managers, and funds, we are exposed to the same perils when we select factors and smart beta strategies. We marvel that these observations are controversial in some circles.”
