Plausible Performance: Have Smart Beta Return Claims Jumped the Shark?

Key Points

  • Performance backtests are often used as evidence to “prove” a smart beta strategy is “better” than its competitors. In our view, careful attention must be given to these claims because backtested results are easily data mined.
  • The historical distribution of live fund performance is a useful guide to gauge what long-term smart beta strategy returns are truly plausible. We look at 40 years of mutual fund returns and find that consistent outperformance is elusive.
  • If performance claims seem too good to be true, they probably are. Over longer horizons, every strategy will encounter both favorable and unfavorable market conditions.

The number of strategic beta exchange-traded products (ETPs) has exploded in recent years. According to Morningstar, in 2018 nearly 1,500 strategic beta ETPs, representing approximately $800 billion in total assets, existed worldwide, with 132 new products coming to market in that year alone.1 More importantly, the total number of smart beta indices published by index providers and available for tracking has grown even faster, with institutional investors executing these strategies in separate accounts to the tune of billions of dollars.

Investors’ appetite for smart beta strategies is not abating. A recent FTSE Russell smart beta survey revealed that “78% of survey respondents have implemented, are currently evaluating, or plan to evaluate a smart beta strategy” (FTSE Russell, 2019, p. 4). With so much competition and such large numbers of assets at stake, the need for smart beta providers to differentiate their strategies as being “better” is becoming increasingly more intense.

So, what is the means to proving a strategy is better? A performance backtest, of course! Regardless of whether delivery is through an ETP wrapper or an institutional account, nearly all smart beta strategies are touted as having impressive (albeit backtested) excess returns. Many of these backtests have only 10 to 15 years of history and cover a very limited set of market environments. The pressure to generate ever-better backtests may also be a response to recently disappointing results of many smart beta strategies.2

The confluence of shorter time horizons, increased competition, and recent underperformance may well have led to smart beta backtests “jumping the shark,” that is, reporting utterly implausible return outcomes. Jumping the shark refers to the outlandish storyline of the 1970s American television sitcom Happy Days that followed one of the show’s main characters, Fonzie, on a California vacation as he accepted a dare to jump over a caged man-eating shark while on water skis. Now viewed as a pejorative term, jumping the shark refers to outrageous plot devices designed to generate attention.

It is our understanding that at least one factor strategy provider is claiming a 4% annualized excess return over the last 10 years, without incurring a single calendar year of underperformance versus the cap-weighted index. This and similar claims by other providers, like the Fonz’s biker-turned-stunt-skier routine, definitely get attention, but are they plausible? In this article, we examine live US mutual fund track records over the last 40 years to gain an intuition into how much outperformance is reasonable for the most superior smart beta strategy (or for that matter, active manager). We call this return “plausible outperformance.”3