Did smart beta go ‘horribly wrong’?

In 2016, we published a paper titled ‘How can ‘smart beta’ go horribly wrong?’, the first in a series on the future of factor investing and other forms of so-called smart beta. Did smart beta go horribly wrong? Yes and no. 

Almost all variants of smart beta fell far short of artificially inflated expectations. Many failed outright, delivering negative alpha in the subsequent years. Today, the opposite holds true. For many strategies, performance prospects are outstanding. We are bullish now for the mirror image of the reasons we were cautious then. Indeed, most factors today are trading in their cheapest quintile in history.

To begin our review of the 2016 paper, we calculate the relative valuations as of 31 March 2016 for five of the most popular factors in four segments of the global equity markets: quality, low beta, momentum, size and value. For each of these factors, we calculate the historical range of relative valuation for each factor based on an average of four common relative valuation measures. 

In each case, and at each point in time, the blended average relative-valuation multiple is calculated for the long portfolio as a ratio relative to the short portfolio. We display our results in figure 1. Some factors always trade cheap (eg, value, where value stocks always trade at a discount to growth stocks, by definition), while others trade rich (eg, quality and momentum). The key point is whether a factor is trading richer or cheaper than its own historical norms.

Most factors trading above historical norms in 2016

Consider the leftmost blue bar, which represents the quality factor in US large-cap stocks. From mid-1968 to March 2016, we calculate a blended relative-valuation ratio for the 30% of the US large-cap market with the highest gross profitability, relative to the 30% with the lowest gross profitability. The top and bottom of the bar indicate the 10th and 90th percentiles, respectively, of the historical relative valuation for our high-profitability portfolio relative to our low-profitability portfolio versus the short portfolio.

The bar (on a log scale) runs from 1.4 to 2.4, meaning that over this full span the market rarely pays less than a 40% premium or more than a 140% premium for high-quality stocks relative to low-quality stocks. 

Each bar also has a white dash and a circle. These represent the prior median relative valuation for each factor, and the then-current relative valuation. For quality, the circle on the bar rests slightly below the median line. In March 2016, high-quality US large-cap stocks were priced at an average premium of 84% relative to low-quality stocks; this was near the long-term historical median premium of 90%. 

“Most factors today are trading in their cheapest quintile in history” 

Applying the same method to the other factors, we find seven of nine factors in the US market were at or above historical norms of relative valuation as of March 2016. No wonder US multi-factor strategies fell far short of expectations – most failing to add any value at all – in subsequent years.

Back then, quality, low beta, momentum, and size were all trading at substantial premiums on a relative valuation basis across the developed markets, and value was trading at a discount in all non-US regional markets. We can think of valuations far removed from the historical median as a stretched rubber band, which history shows tend to snap back; in other words, the relative valuations tend to mean revert.

Converting each of the March 2016 relative valuation measures to a Z-score (log scale) measures how far the rubber band was stretched away from historical norms (figure 2). Fifteen of the 19 factors were trading rich, above historical norms. Nine of the 15 not only failed to match their historical success, but actually hurt investors over the subsequent six-and-a-half years. 

Of the four factors trading cheap in March 2016, two added value in the subsequent six-and-a-half years. Seven of the nine US factors were trading rich, and five out of the seven hurt their investors. Is it any wonder multi-factor strategies fell short of investors’ expectations?

For any given year, the relationship between cheapness relative to history and subsequent factor performance is weak, but over longer spans, it is surprisingly strong. The diagonal dotted line in figure 2 shows that each one-sigma shift away from historical norms was worth about 110bps a year in relative performance for the six-and-a-half-year period ending 30 September 2022. 

While this sounds modest, it is not: the quintile with the lowest relative valuation beat the quintile with the highest by 570bps per annum six-and-a-half years, a cumulative performance gap of 3,700bps. The intercept on the graph, at a Z-score of zero, is approximately 44 bps a year. While far short of historical norms, it is positive. Factor investing has merit, even if the evidence of the last several years is not encouraging.

Most factors now trading cheap relative to history

Fast forward six-and-a-half years. Low beta and momentum have swung from very expensive to very cheap for US large-cap stocks. Quality beat performance expectations, in part because high-profitability stocks became more expensive relative to low-profitability stocks, leaving quality as the most expensive US factor today. Value fell far short of expectations, in part because value stocks got much cheaper relative to growth stocks, leaving US large-cap value at the 15th percentile of historical relative cheapness for the value factor.  

In a near-perfect mirror image of the situation in 2016-17, of the nine US factors, seven are now trading cheap relative to history, with six of the seven in the cheapest quintile of the historical range (figure 3). 

Only two are trading rich relative to history and neither is in the top quintile. Of the 19 factors worldwide, 14 are trading cheap, with 11 in their historically cheapest quintile ever. 

Of the five factors that are trading rich relative to history, only one – quality in the developed markets – is in the top quintile of historical relative valuation; this preference for quality is likely a consequence of the geopolitical shocks currently threatening Europe and Japan. 

When money was pouring into multi-factor strategies in 2016-17, it proved to be a terrible time to embrace these strategies. In 2022, after a protracted period of disappointing returns and elevated economic and capital market uncertainty, performance chasing means investors are turning away from poorly performing multi-factor strategies. 

Yet, as these multi-factor strategies shed assets at a prodigious pace, today most factors do not merely look cheap, they look very cheap. Now appears to be a particularly promising time to embrace multi-factor investing.

We urge investors to commit to a few simple practices, such as netting out the effect of changing valuations, rebalancing into disappointing factors or strategies and out of the biggest winners, and adjusting expectations to allow for the possibility of mean reversion to historical norms. These choices, which may seem simultaneously intuitive and unconventional, and at times may steer us towards uncomfortable choices, offer a surer path to investment success. 

Rob Arnott is founder and chair, and Amie Ko is senior vice-president, at Research Affiliates. This article is a version of a paper first published in January 2023