Smart beta is an investment strategy that’s become very popular in recent years. It’s a twist on index investing. The investor starts with an index but tweaks the stock allocations so that they are weighted by something other than capitalization. There are many variants of smart beta, and it is estimated that one out of five new exchange-traded funds the last few years of smart beta.
That’s why it’s important that one of the original smart beta investors, Rob Arnott and his team at Research Affiliates, recently issued a paper that is highly critical of smart beta. In fact, Arnott and company say that smart beta likely is a bubble that’s going to pop. Arnott’s key argument is that, while his approaches include stock valuations, most smart beta strategies ignore valuation. He says that looking at history, you’ll find that strategies outperformed only because investors ignored valuations and focused only on recent returns. They kept buying, pushing valuations for the strategy higher, until the valuations became unsustainable. Arnott promises more papers critical of many varieties of smart beta in coming months.
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.