Research Affiliates founder Rob Arnott.

How can smart beta go horribly wrong? Performance chasing, according to Rob Arnott, founder and chairman of Research Affiliates.

In a presentation at Inside Smart Beta in New York on Thursday, Arnott spoke about this and other pitfalls of investing in smart beta.

“It’s easy to get into the performance-chasing game,” he told the crowd. “Now anything that is newly expensive, probably got there by dint of having wonderful performance, right? If there’s any mean reversion, it’s probably going to have lousy future performance. Buy high, sell low. Anything that’s newly cheap probably got there by inflicting pain and losses, which means people probably bailed out. And if there’s any mean reversion, it’s likely to have wonderful future performance.”

Most investors are already practicing a form of factor timing – but in the wrong direction, according to Arnott. He says investors fund the success of contrarian investors by buying high and selling low.

“It’s endemic. It’s human nature,” he said. “Our ancestors did not survive … by running towards a lion. In the capital markets, what looks like a lion typically is a pussycat who’s gotten pretty tired.”

Arnott’s advice is to emphasis factors or strategies that are trading cheap relative to their own historic norms and de-emphasize the more expensive factors or strategies. In that way, he says, “we can improve performance.”

New research by Research Affiliates finds that the winning approach to factor investing is buying the losers. “Past negative performance appears to be predictive of positive future returns,” it concludes. 

The problem is that performance chasing is endemic to the industry, Arnott said.

Arnott also called out a paper he wrote in 2016 that concluded that 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. 

Arnott revaled that new research from Research Affiliates will examine “the folly of watch lists.”

“You underperform for two years back-to-back, you’re on a watch list. Some call it a penalty box,” Arnott said. “You get put in a penalty box, you’re expected to work harder and think harder. As if.”

But, in Arnott’s point of view, if a strategy has underperformed and has become “massively cheaper” in the process, that’s a buy not a sell. And, contrarily, if a strategy has outperformed and become “massively more expensive” in the process, Arnott says that’s a sell not a buy.

If a strategy has underperformed and has not gotten cheaper, though, Arnott says, “oh my goodness, get rid of it.”

However, if a strategy has outperformed and has not gotten massively more expensive and is the same valuation relative to the market as it was before, Arnott calls that “a pretty golden strategy.”

“We all know that investors look at the best historical performance before they invest,” Arnott said. “We should also look at relative valuation, which they usually don’t.”

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