Looking at U.S. equities’ dramatic rise in the latter half of the 20th century, which generated an 8 percent average annualized return, Arnott said that half of the increase could be attributed to the relative rise of valuation levels, thus the real return on stocks was 4 percent, not eight.
Using the same method to compare various smart beta factors, Arnott found that two factors, momentum and illiquidity, produce significant long-term alpha; two more, value and size, produce moderate long-term returns; while low beta and quality factors produce insignificant results.
The smart beta crash, then, is a behavioral one, says Arnott: Investors are buying smart beta products expecting outperformance, when they could see underperformance in the future as valuations revert to the mean.
“If you buy a strategy expecting a 4 percent alpha is likely to be achieved in the future and you end up with negative 4 percent, that’s smart beta gone horribly wrong,” Arnott said. “If enough people pile into these strategies, that’s a smart beta crash.”
Investors should also compare strategies, said Arnott. When comparing equal weighting, fundamental indexing, risk-efficient strategies, low volatility, maximum diversification and quality strategies, Research Affliates found that all six are capable of producing alpha, but in five cases their relative valuations are expensive compared to history.
“Value and value-related smart beta are cheap right now compared to history,” Arnott said. “What a great time to consider committing some assets to value-related smart beta or deep value strategies.”