Smart beta funds are not just attracting column inches, they are also winning assets.
A Financial Times article back in May noted that smart beta funds – those not organized around a market capitalization index, but around an index based on a stock characteristic or factor such as valuation, price momentum or profitability – had taken in $24 billion in the first quarter of the year. That represents an increase of more than 2,000% on the $1 billion that these funds gathered in the same quarter of 2016.
Smart beta strategies may use different factors, but Rob Arnott of Newport Beach-based Research Affiliates has aptly defined the approach as establishing an index that ‘breaks the link’ between market capitalization or stock size and the rank in the index.
Back in 2005, Arnott founded what could be called the first smart beta strategy – the RAFI, or the Research Affiliates Fundamental Index – which ranked stocks according to sales, earnings, book value and dividends. This strategy is the basis of the Pimco RAE Fundamental Plus fund, which ranks in the top percentile of large value funds in Morningstar’s universe for the 10-year period to September 2017. Over that decade, the fund outpaced the S&P 500 Index by 3.63 percentage points annually.
But Arnott is no straightforward cheerleader for smart beta. He has been an outspoken critic of investors chasing strategies based on factors that have performed well recently. Such factors might be overvalued relative to their own historic metrics, and could therefore be poised to deliver subpar returns in the future. Arnott has also amassed an astounding amount of data on smart beta strategies, and makes it available on the Research Affiliates website. We decided to study it to see which strategies are the most overpriced and which might still have some return left in them.
Digging into the numbers
According to this data, four of seven factors are now overpriced compared with their long-term valuation metrics. Momentum, illiquidity, low beta and investment are overpriced, while value, gross profitability and size remain underpriced. Arnott uses the traditional Fama and French price/book value method for the value factor, but also calculates a composite using price/five-year average earnings, price/five-year average sales, five-year average dividends and price/book value. We’ve used the composite.
It’s important to note that the returns aren’t nominal. Nor are they real returns or outperformance versus a benchmark. They are the returns of portfolios in line with Fama and French’s original methodology: being long the 30% of stocks that display the best attributes of a particular factor – low valuation or strong momentum, for example – and being short the 30% of stocks that display the worst factor attributes.
So, for example, the gross profitability factor’s historical valuation of 1.89 means that the 30% most profitable stocks are typically 1.89 times more expensive than the 30% least profitable stocks. When the current valuations exceed the historical valuations, investors should be prepared for subpar subsequent returns. In the case of gross profitability, its current 1.83 reading is largely in line with its history.
It’s also important to note that another section of the Research Affiliates website applies the expected return methodology to different investment strategies based on the factors. So, for example, an actual investment strategy that tilts toward the value factor can select and weight stocks by traditional price/book, something closer to Arnott’s composite, or even his fundamental index.
Top and tails
The worst valuation and expected return now belong to the low beta factor, with its current valuation clocking in at 51% higher than its historical valuation. Investors, understandably scarred by the experience of the 2008 financial crisis, have flocked to this strategy as a means of gaining stock exposure without the painful drawdowns.
The low beta factor was discovered by a finance professor named Robert Haugen, who argued against modern academic finance’s assumption that higher volatility must be associated with higher returns. Haugen, a student of Benjamin Graham, correctly surmised that unloved lower volatility stocks such as behemoth consumer products companies could grind out market-beating returns over time, while the more glamorous stocks soared and then crashed.
But the data from Research Affiliates shows that Haugen’s basic insight may now be too popular to work the way investors might hope. A portfolio long the lowest beta stocks and short the highest beta stocks is likely to deliver negative returns over the next five years.
The good news is that the value factor – the first one discovered by Fama and French – might help portfolios over that same period. That makes some sense given that the Russell 1000 Growth index has outpaced the Russell 1000 Value index by 3.16 percentage points annually over the past 10 years to the end of September 2017. Over a three-year period, the growth index has surpassed the value index by 4.17 percentage points annually.
The Research Affiliates value composite’s expected return is 4.58% for the next five years. In part, that estimate is based on the observation that value stocks themselves have suffered valuation compression in recent years. Because of that, the firm’s model boosts the factor’s future return estimate, according to Noah Beck, an equity research analyst at Research Affiliates.
Investors should not add factors to portfolios indiscriminately and assume they will perform in the same way they have in the past. And investors who have chased low volatility stocks hoping to achieve market-beating returns with lower volatility may be in for a nasty surprise. As ever, valuation matters, and the value factor appears to have the cheapest valuations right now.