How Can “Smart Beta” Go Horribly Wrong?

Key Points

  • Factor returns, net of changes in valuation levels, are much lower than recent performance suggests.

  • Value-add can be structural, and thus reliably repeatable, or situational—a product of rising valuations—likely neither sustainable nor repeatable.

  • 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.

  • We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies.

This is the first of a series on the future of smart beta.

Because active equity management has largely failed to deliver on investors’ expectations,1 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.