by Rob Arnott, Vitali Kalesnik, John West, and Noah Beck
According to Panel B of this paper, the 10-year annualized excess return of low volatility through Sep 30, 2015 (2015Q3) was 0.82%. According to S&P http://us.spindices.com/indices/strateg ... lity-index , the 10-year return of the S&P 500 Low Volatility and "regular" indices through Feb 12, 2016 was 8.91% vs. 6.18%, a much larger difference of 2.73%. I wonder if the difference is due just to the different time periods covered or if different definitions of low volatility are being used.Because active equity management has largely failed to deliver on investors’ expectations, 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.