Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

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Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by Aish » Sun Feb 14, 2016 7:43 pm

A particularly insightful article that I thought people here would enjoy. It makes me reconsider tilting in my own portfolio. Some interesting quotes:
"some smart-beta techniques have outperformed mainly by becoming dangerously expensive"

"Morningstar [...] estimates that $72.9 billion in new money poured into such funds last year. By the end of 2015, they held $565 billion"

"Looking at a dozen smart-beta approaches, Research Affiliates found that nearly all were cheaper than the rest of the market a decade ago but now trade at premium prices"

"Consider low-volatility stocks, which fluctuate less than average. From the 1970s through the early 2000s, they were about half as expensive as the overall market. Today, reckons Research Affiliates, they are about 20% more costly than other stocks.

Take away this recent price gain, and low-volatility stocks offer virtually no extra return, Mr. Arnott says. “All the value they’ve added has come from getting more expensive,” he warns."

"Because computers and access to data are proliferating, the odds that strategies are based on “statistical flukes without theoretical support” is rising, warns Marcos López de Prado, a senior managing director at Guggenheim Partners, an investment firm in New York that manages about $240 billion."

"investors should be particularly wary of strategies that have become richly priced—including many specializing in high-dividend, low-volatility and “high-quality,” or robustly profitable, stocks"
http://www.wsj.com/articles/chasing-hot ... 1455319331

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by David Jay » Sun Feb 14, 2016 7:51 pm

Jason is one of the few financial writers that I "expect" will get it right, and thus is worth reading.
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by mjb » Sun Feb 14, 2016 7:51 pm

This is another point of consideration in the small-large, growth-value debate.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by Rick Ferri » Sun Feb 14, 2016 7:57 pm

Nothing fails like success when it comes to active management strategies. Big returns attract big money which leads to small returns and underperformance.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by larryswedroe » Sun Feb 14, 2016 8:00 pm

Rick
True but it can also apply to passive strategies and fwiw IMO it has already happened to dividend strategies and low volatility strategies, and perhaps quality/profitability strategies

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by JoMoney » Mon Feb 15, 2016 7:07 am

We're almost 10 years out from Mr.Bogle's WSJ op-ed "Turn on a Paradigm?"
I don't think anyone was using the term "Smart Beta" at the time, but he cautioned
John Bogle, WSJ op-ed June 27,2006 wrote:.. to the extent that investors are persuaded by these data, the premiums offered by such stocks may well now have been "arbitraged away" in the stock market, as price-earnings multiples have become extremely compressed. ...

We never know when reversion to the mean will come to the various sectors of the stock market, but we do know that such changes in style invariably occur. Before we too easily accept that fundamental indexing -- relying on style tilts toward dividends, "value" and smallness -- is the "new paradigm," we need a longer sense of history, as well as an appreciation that capitalization-weighted indexing does not depend on efficient markets for its usefulness.
While we have witnessed many "new paradigms" over the years, none have persisted. ...

Intelligent investors should approach with extreme caution any claim that a "new paradigm" is here to stay. That's not the way financial markets work.

At least the RAFI fund (PRF) seems to have held up better than Siegel's dividend "factor" (DTD) or DFA's Small-Value (DFSVX) relative to Total Stock (VTI)
Morningstar Chart
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by sunnywindy » Mon Feb 15, 2016 9:19 am

The original link doesn't work if you aren't a WSJ subscriber. Here's a link that does: http://blogs.wsj.com/moneybeat/2016/02/ ... dumb-idea/
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by betablocker » Mon Feb 15, 2016 9:30 am

Are we lumping the Fama and French value and size premium factors into the "Smart Beta" category? It's a slippery term http://www.investopedia.com/terms/s/smart-beta.asp more about marketing than anything else. Is the dumb part looking for factors under every mattress to invest in or is Zweig saying that all factors that deviate from buying the total market are dumb?

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by Aish » Mon Feb 15, 2016 10:04 am

betablocker wrote:Are we lumping the Fama and French value and size premium factors into the "Smart Beta" category? It's a slippery term http://www.investopedia.com/terms/s/smart-beta.asp more about marketing than anything else. Is the dumb part looking for factors under every mattress to invest in or is Zweig saying that all factors that deviate from buying the total market are dumb?
They did specifically talk about Profitability/Quality which is one of the newer factors that Fama & French have put out.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by lack_ey » Mon Feb 15, 2016 10:08 am

Related thread not about the article but the primary source:
viewtopic.php?f=10&t=184573&newpost=2801801
betablocker wrote:Are we lumping the Fama and French value and size premium factors into the "Smart Beta" category? It's a slippery term http://www.investopedia.com/terms/s/smart-beta.asp more about marketing than anything else. Is the dumb part looking for factors under every mattress to invest in or is Zweig saying that all factors that deviate from buying the total market are dumb?
Zweig's writing here in this article follows Arnott's ideas, so the warning is not as broad as that.

At the end, for example:
Be on your guard if a fund’s holdings have a higher ratio of price to earnings or book value than they did in the past, or than the market does now. You don’t want smart beta to leave you feeling stupid.
It is not actually all that dismissive of smart beta, just reminding people that many results may or may not be robust, and much of the performance of certain strategies in the past can be a result of rising valuations, which probably won't go on indefinitely.

Value is cheaper than it was say 10 years ago, at least by price/book (which is itself the sort on value in Fama-French). That may or may not be actually cheap, but the change contributed to relatively poor performance over that period and now looks less worrisome by this simple measure.

Keep in mind that even in the past data, for many of the factors, the valuations weren't all that predictive of future returns.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by nedsaid » Mon Feb 15, 2016 11:18 am

The irony of ironies, it might turn out that the smartest beta is beta itself. That is exposure to an untilted Total US Stock Market Index and a Total International Stock Index. The only factor exposure is beta itself.
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by Rick Ferri » Mon Feb 15, 2016 1:45 pm

larryswedroe wrote:Rick
True but it can also apply to passive strategies and fwiw IMO it has already happened to dividend strategies and low volatility strategies, and perhaps quality/profitability strategies

Larry
Yes, but difficult in a total market fund unless stocks in general become overvalued such as in 1999. I'm not sure if your saying that dividend et all are passive or active active strategies. IMO, any strategy that selects securities based on factors and weights securities on other than market cap is active, not passive.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by garlandwhizzer » Mon Feb 15, 2016 1:53 pm

The take home message from Rob Arnott's piece is that Low Vol, profitability, and quality are expected to produce no above market return going forward due to their current overvaluations. Value however isn't so expensive according to him and is still expected to produce above market returns largely because of its underperformance relative to basic market indexes for the last 12 years and also relative to those other currently undesirable strategies. So presumably this is the time to load up on value and particularly SCV which is the darling of value investors.

It is interesting to look at Research Affiliates (Rob Arnott's firm) projections of expected 10 year real returns and volatility for various asset classes. The last such projection was dated 1/16/2016 so it is entirely up to date. Interestingly in those projections, US small cap is expected to produce less than a 1% real 10 year return with a volatility measurement of almost 20%. US large cap is expected to produce slightly higher return with slightly less volatility. So the small factor is not expected to give any market beating returns, in fact the slightly the opposite. How much then can SCV outperform small going forward for the next decade? Of course no one knows this with certainty and a real possibility exists that SCV will not outperform at all. Arnott seems to think there will be some positive outperformance but does not quantify it exactly.

I believe one point that has to be made is the following. If you believe that loading up on US SCV now is going to make you rich over the next decade, that is an unlikely outcome. US SCV would have to massively outperform US SC to make a big positive impact on your portfolio at all if Mr. Anott's 10 year expected return projections are correct. Looking at the various expected asset class returns one would expect that the optimal strategy to increase portfolio return is to increase allocation now to INTL (5 times expected return of US SC with less volatility) and especially EM (9 times expected return of US SC with somewhat greater volatility). In view of these huge differences in RA's expected 10 year returns, it seems like arguing over which factors are going to outperform in the US market are perhaps missing the main point. The expected risk/reward tradeoff appears to be hugely better outside our beloved shores than in the US going forward if Arnott is on target. Of course these are only predictions of the future which by their very nature are flawed and often inaccurate. But they are no more inaccurate inherently than future projections of SCV outperformance.

Mr. Arnott believes that Low Vol, quality, are profitability are all currently overpriced. Why? Could it be that aging demographics, the massive numbers of baby boomers who are either soon retiring or already retired have collectively decided to structure their equity portfolios at a lower risk level? This is a real possibility and it may be a secular rather than a cyclical change in equity investment preference. All developed economies have aging populations with considerable savings to invest and their prime motivation may not be to buy and hold indefinitely onto SCV--small, distressed, high-risk companies--waiting for a distant payoff. Instead they may prefer to hold solid companies who have cash on the balance sheet and make money reliably come thick or thin. This preference leads into factors like Low Vol, quality, and profitability, perhaps driving up their valuations, but is this going to change as most of those who have the real money to invest significantly get older and more risk averse in their investing strategy. They of course can increase bond holdings to reduce risk, but essentially no one expects bonds to produce significant positive real returns over the next decade. In short these factors dismissed as overvalued by Arnott, may continue to be popular and overvalued, and may not revert to the mean as defined by Arnott.

One final word. An approach which to me looks better with every passing year relative to the ever changing factor zoo is to buy and hold TSM for US equity exposure. I believe this is an entirely rational choice. Even as more and more funds and professionals try to beat TSM, they may overgraze exactly what they seek. As the years pass by, it seems to get harder and harder to beat simple ultra-low cost indexes on an after cost basis.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by tc101 » Mon Feb 15, 2016 2:00 pm

IMO, any strategy that selects securities based on factors and weights securities on other than market cap is active, not passive.
Rick, are you saying that:

1. The only passive approach is total US stock fund and total international stock fund?
2. You think that passive approach is the best approach?
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by larryswedroe » Mon Feb 15, 2016 2:04 pm

Rick
That definition is fine as long as you state it that way.

I view passive investing differently. There are two decisions to make, your AA and your implementation. For AA one could argue that any strategy other than GLOBAL TSM is active. So owning US TSM only or underweighting international is ACTIVE.

My own focus is on implementation. If the strategy doesn't involve any INDIVIDUAL stock selection nor any market timing, but uses rules based decisions to gain exposure to well documented factors that include more than just beta, is passive. So RAFI, Wisdom Tree, DFA, Bridgeway, AQR are all passive in terms of implementation.

Now I have no problem at all with someone choosing another definition. Whatever one chooses though one should be consistent.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by nedsaid » Mon Feb 15, 2016 2:28 pm

garlandwhizzer wrote:The take home message from Rob Arnott's piece is that Low Vol, profitability, and quality are expected to produce no above market return going forward due to their current overvaluations. Value however isn't so expensive according to him and is still expected to produce above market returns largely because of its underperformance relative to basic market indexes for the last 12 years and also relative to those other currently undesirable strategies. So presumably this is the time to load up on value and particularly SCV which is the darling of value investors.

Nedsaid: Garlandwhizzer, the chief market strategist for the Bogleheads. I say this as a compliment as I enjoy your posts. Pretty much Mega-dittos here.

It is interesting to look at Research Affiliates (Rob Arnott's firm) projections of expected 10 year real returns and volatility for various asset classes. The last such projection was dated 1/16/2016 so it is entirely up to date. Interestingly in those projections, US small cap is expected to produce less than a 1% real 10 year return with a volatility measurement of almost 20%. US large cap is expected to produce slightly higher return with slightly less volatility. So the small factor is not expected to give any market beating returns, in fact the slightly the opposite. How much then can SCV outperform small going forward for the next decade? Of course no one knows this with certainty and a real possibility exists that SCV will not outperform at all. Arnott seems to think there will be some positive outperformance but does not quantify it exactly.

Nedsaid: My guess is that plain old boring Value will be the place to be in the U.S. Markets in the future. Small Value might do a bit better. Unfortunately, I think the market will be a Growth market for a few more years. In my unscientific, fly-by-the-seat-of-my-pants way of thinking, I am thinking the switchover will be about the year 2020. The 1990's were a US Large Growth decade, and the 2000's were a US Small and US Value Decade and International Stocks did better than US Stocks. The 2010's look like a return to the 1990's, a US Large Growth decade.

I believe one point that has to be made is the following. If you believe that loading up on US SCV now is going to make you rich over the next decade, that is an unlikely outcome. US SCV would have to massively outperform US SC to make a big positive impact on your portfolio at all if Mr. Anott's 10 year expected return projections are correct. Looking at the various expected asset class returns one would expect that the optimal strategy to increase portfolio return is to increase allocation now to INTL (5 times expected return of US SC with less volatility) and especially EM (9 times expected return of US SC with somewhat greater volatility). In view of these huge differences in RA's expected 10 year returns, it seems like arguing over which factors are going to outperform in the US market are perhaps missing the main point. The expected risk/reward tradeoff appears to be hugely better outside our beloved shores than in the US going forward if Arnott is on target. Of course these are only predictions of the future which by their very nature are flawed and often inaccurate. But they are no more inaccurate inherently than future projections of SCV outperformance.

Nedsaid: Yes, I believe values are in the International Stock Markets particularly Emerging Markets. I talk a good game on International but my allocations haven't changed as the US Market has outperformed International Markets now for a few years. My new monies for stocks are split 50% US and 50% International and have been for years.

Mr. Arnott believes that Low Vol, quality, are profitability are all currently overpriced. Why? Could it be that aging demographics, the massive numbers of baby boomers who are either soon retiring or already retired have collectively decided to structure their equity portfolios at a lower risk level? This is a real possibility and it may be a secular rather than a cyclical change in equity investment preference. All developed economies have aging populations with considerable savings to invest and their prime motivation may not be to buy and hold indefinitely onto SCV--small, distressed, high-risk companies--waiting for a distant payoff. Instead they may prefer to hold solid companies who have cash on the balance sheet and make money reliably come thick or thin. This preference leads into factors like Low Vol, quality, and profitability, perhaps driving up their valuations, but is this going to change as most of those who have the real money to invest significantly get older and more risk averse in their investing strategy. They of course can increase bond holdings to reduce risk, but essentially no one expects bonds to produce significant positive real returns over the next decade. In short these factors dismissed as overvalued by Arnott, may continue to be popular and overvalued, and may not revert to the mean as defined by Arnott.

Nedsaid: One pocket of value for bond investors are the much maligned TIPS bonds. Grok87 pointed me to a Vanguard post that hinted at bargains in this space. Larry Swedroe has made similar comments. TIPS are also on my "buy" list.

One final word. An approach which to me looks better with every passing year relative to the ever changing factor zoo is to buy and hold TSM for US equity exposure. I believe this is an entirely rational choice. Even as more and more funds and professionals try to beat TSM, they may overgraze exactly what they seek. As the years pass by, it seems to get harder and harder to beat simple ultra-low cost indexes on an after cost basis.

Nedsaid: Yes, the factor restaurant is getting pretty crowded now except for Value. Though I favor small/value tilting, I have let my portfolio drift. I am not doing growth to value or large to small rebalancing as I figure the Large Growth trend will continue for some time. When I read more and more that factor investing is absolute bunk, then I will probably be more interested in the factors again. I am referring to the late Yogi Berra's quote about "that Restaurant being so crowded that no one goes there anymore."
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by bertilak » Mon Feb 15, 2016 3:00 pm

sunnywindy wrote:The original link doesn't work if you aren't a WSJ subscriber. Here's a link that does: http://blogs.wsj.com/moneybeat/2016/02/ ... dumb-idea/
Didn't work for me, but this did: http://www.wsj.com/articles/chasing-hot ... 1455319331
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by JoMoney » Mon Feb 15, 2016 3:01 pm

nedsaid wrote:The irony of ironies, it might turn out that the smartest beta is beta itself. That is exposure to an untilted Total US Stock Market Index and a Total International Stock Index. The only factor exposure is beta itself.
It may not be the smartest investment, it may not be that beta is a factor at all, but buying the broad market through an index fund with almost no trading is a good way to avoid a lot dumb mistakes people make when trying to garner something above what the market is giving.
Warren Buffett 1993 Annual BRK Letter wrote:Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong...

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock...

...By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by bertilak » Mon Feb 15, 2016 3:27 pm

JoMoney wrote:
Warren Buffett 1993 Annual BRK Letter wrote:It is better to be approximately right than precisely wrong...
One of my hot buttons, since way before I ever invested in anything. It goes back to my engineering education. Some professor probably said the equivalent and it struck a nerve.

Of course it is better yet to be precisely right!
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by JoMoney » Mon Feb 15, 2016 3:36 pm

bertilak wrote:
Warren Buffett 1993 Annual BRK Letter wrote:It is better to be approximately right than precisely wrong...
One of my hot buttons, since way before I ever invested in anything. It goes back to my engineering education. Some professor probably said the equivalent and it struck a nerve.
Of course it is better yet to be precisely right!
But you better be certain you're 100% "precisely right" :sharebeer
Warren Buffet 2010 Annual BRK Report wrote:...as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero..
http://www.berkshirehathaway.com/2010ar/2010ar.pdf .
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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by pkcrafter » Mon Feb 15, 2016 4:16 pm

I haven't forgotten Rick's take on smart beta.
(1) The cost of beta is basically free (after netting out expenses with securities lending practices). Anything other than beta is more costly so there’s a hurdle rate. These hurdle rates can vary depending on the fund choice so choose wisely.

(2) There is always more risk in smart beta. There’s really no such thing as smart beta, just additional betas and risk.

(3) There are very long periods of underperformance with these strategies. Small cap value underperformed for 18 years in the 80s and 90s. The question is: Can you hang on? Unless you thoroughly understand it there is huge capitulation risk.
http://awealthofcommonsense.com/2014/06 ... mart-beta/

Most Bogleheads will tell you chasing returns in a bad idea, but changing the term to smart beta seems to make it OK. Another case of smart marketing overcoming common sense.

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Re: Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb- Jason Zweig in WSJ

Post by lack_ey » Mon Feb 15, 2016 4:36 pm

JoMoney wrote:
nedsaid wrote:The irony of ironies, it might turn out that the smartest beta is beta itself. That is exposure to an untilted Total US Stock Market Index and a Total International Stock Index. The only factor exposure is beta itself.
It may not be the smartest investment, it may not be that beta is a factor at all, but buying the broad market through an index fund with almost no trading is a good way to avoid a lot dumb mistakes people make when trying to garner something above what the market is giving.
I'm picking a lot of nits, but I think the distinctions are important.

Beta is not a factor. It is the coefficient for a factor, usually in most contexts the market factor, which has precise definitions. The market factor is unambiguously a factor by construction and accepted convention. For decades it's been used to help describe and interpret investment returns. With respect to explanatory power, it has some use as a modeling tool.

As far as I can tell, you're speaking to the future returns of the market factor, which are unknown. Nobody actually knows for sure if it will be positive or negative or what, and to what degree. The historical return of the market factor provides some limited clues about the future returns. But sure, maybe the market factor—or market minus risk-free, if you prefer that—doesn't provide any returns over the long run.

Regardless of the returns of a factor, they still provide information about asset performance. If the market factor returns -15% over a period of time, a diversified asset allocation with a market beta of 0.8 probably lost money, probably with a return close to -12% unless it's full of all kinds of other stuff too.

When examining the broader factor zoo, many of the factors are significantly overlapping. That means that some can be used to explain the results of others to a reasonable degree from a modeling perspective, at least on past returns. In that sense they may not necessarily be "real" or very much expanding the space. But that doesn't make them not factors as defined and doesn't make them necessarily useless, especially with regards to devising investment strategies.

You could, for example, describe a low volatility factor as some time-varying combination of other factors like value and size and whatever else, but this is largely irrelevant for somebody attempting to beat the broader market in some sense. What you'd really be interested in is whether or not low volatility as described leads to any excess return or at least better risk/return characteristics. As long as it works, it doesn't really matter if any performance difference is really because of the low volatility or something else that's incidentally captured. On the other hand, Rob Arnott's point about factor valuations does play some role into explaining the performance of factors and what we might expect from them in the future. If excess performance came from rising valuations over a period, they may be less durable in the future.

pkcrafter wrote:Most Bogleheads will tell you chasing returns in a bad idea, but changing the term to smart beta seems to make it OK. Another case of smart marketing overcoming common sense.
Almost all investing is about chasing future returns. I use bonds instead of cash (to a certain extent) because I expect higher returns from bonds a lot of the time in the future, more relevantly with a decent probability in the near future. "Chasing returns" is generally used derogatorily in situations of changing allocations into favoring somewhat recent outperformers (say in the last few or several years), which has been generally shown to be a bad idea. A lot of smart beta is not necessarily about chasing returns in this sense. It depends on what you're looking at.

Smart beta and factor investing are ways to capture something different from the broad market. This may be a good or a bad thing. Some would always call it a bad thing or at least prefer not to partake themselves. Fine. They're generally cheaper and more transparent than traditional active management (also more mechanical, less flexible) and for many people may be used as a partial or complete substitute for active management in an attempt to capture higher returns, lower risk, or whatever else. Obviously, the market being what it is, many will fail to capture those things. In any case, it's just another option out there that can be exploited or ignored.

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