In a reprise of a 2016 research paper that sparked a row with AQR founder and chief investment officer Cliff Asness, Research Affiliates founder and chair Rob Arnott urges investors to reconsider out-of-favour factor investment strategies.
Writing this month, Arnott now believes his cautious approach seven years ago was vindicated.
He writes: “In short, 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.”
As IPE reported at the time, some Dutch pension funds have retreated from underperforming factor strategies, among them the schemes of Akzo-Nobel, Rabobank and Robeco.
Arnott adds: “Yet, as these multi-factor strategies shed assets at a prodigious pace, today most factors do not merely look cheap, they look very cheap!”
Research Affiliates finds that of 14 out of 19 factors globally are trading at attractive levels, with 11 of those in their historically cheapest quintile. These include developed momentum and value; emerging market low beta, momentum and value, and a further six US factors.
Conversely, developed markets quality stocks are expensive – although it is the only one of five such expensive factors to be in the top quintile of historic relative valuation, which Arnott attributes to the current geopolitical crisis.
There are signs that factor investing strategies are returning to favour: in Invesco’s 2022 Global Factor Investing Study, 64% of respondents said they now had more faith in factor strategies than in the previous year.
Arnott’s 2016 paper How ‘Smart Beta’ Can Go Horribly Wrong, the first in a series published over the following 18 months, argued that “factor returns net of changes in valuation levels” are much lower than recent performance suggested.
As he wrote at the time: “Many investors are performance chasers who in pushing prices higher create valuation levels that inflate past performance, reduce potential futures performance and amplify the risk of mean reversion to historical valuation norms.”
A “smart beta crash” was at the time a “reasonable possibility”.
In a 2016 rejoinder, The Siren Song of Factor Timing, Asness found the benefit of “timing strategies to be very weak historically”, adding that timing factors could re-introduce a type of skill based active management.
Asness also referred to market timing as a “sin”, advising practitioners: “If you time the factors, and I don’t rule it out completely, make sure you only ‘sin a little’.” His advice at the time was to invest in factors for the long term and to diversify across them.
Writing now, Arnott again stresses the importance he sees in recognising relative valuations – “revaluation alpha” – and warns against backtesting, “perhaps more widely used in marketing than ever before”.
He also notes that academics seeking tenure have “no better path to that goal than to identify a new factor that has generated great past performance” but also lack an incentive to test for “upward revaluation”.
Arnott calls on investors and academics to “commit to a few simple, critical and often underappreciated practices”, including to net out the effect of changing valuations, rebalance into disappointing factors and out of the biggest winners, and to adjust expectations to allow for mean reversion.