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Smart Beta Strategy Is Ripe for a ‘Crash’: Research Affiliates

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Smart beta, one of the fastest growing investment strategies used by financial advisors, may be setting itself up for a fall. In a rather scathing report, Research Affiliates’ analysts led by the firm’s Chairman and CEO, Rob Arnott, write that much of returns of the smart beta strategies is due to their growing popularity, which increases valuations, rather than their “structural alpha,” which is the quality of that strategy to beat its benchmark on a sustainable and repeatable basis.

“Factor returns, net of changes in valuation levels, are much lower than recent performance suggests,” according to the report, written by Arnott, Noah Beck, Vitali Kalesnik and John West. “We think it’s reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies.”

The authors write that many smart beta strategies have performed well simply because they have become popular among investors, who end up chasing performance as they have typically done with other investments.

“Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive…. Absent rising relative valuations, there’s nothing left! In that case “smart beta is, well, not very smart,” the authors write

According to an FTSE Russell report, 68% of financial advisors polled are using smart beta ETFs and 70% indicated that performance history is a key reason in choosing a smart beta strategy. Create-Research reports that smart beta ETFs comprise over $300 billion in assets, or 18% of the U.S. ETF market.

Research Affiliates looked at the performance of six popular smart beta strategies over the past 10 years (2005 Q4 — 2015 Q3) and almost 49 years (1967–2015 Q3): equal weight (the 1,000 largest-cap stocks, equally weighted), Fundamental Index, risk efficient, maximum diversification, low volatility and quality, defined as profitability, leverage, and earnings volatility.

It found that the rising relative performance of low volatility, maximum diversification, and quality strategies was due largely to rising relative valuations. Over the 10-year period, the low vol strategy yielded a 0.82% annual return but the return from changing valuations was 1.65% a year. “Thus, more than 100% of its return came from expanding valuations!”

The maximum diversification strategy generated a 1.59% annual return but a loss, or negative return, once the 1.62% annual gain from rising valuations was excluded.

“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,” write the authors. “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.”

The authors advise that “Investors need to look under the hood to understand how a strategy or factor produced its alpha” and “make every effort to avoid being duped by historical returns.”

Kalesnik, head of equity research at Research Affiliates, told ThinkAdvisor that before investors adopt smart beta strategies they should study different offerings and learn how a particularly strategy has outperformed over time. They should find a way to access that strategy in a cost-effective way, taking into account trading costs and expense ratios and fees.

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