Research Affiliates: That was then, this is now
By Rob Arnott, Founder and Chairman of Research Affiliates
In 2016, we published a paper titled How Can ‘Smart Beta’ Go Horribly Wrong?, the first in a series of papers 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.
That was then
To begin our review, we calculate the relative valuations as of March 31, 2016 for five of the most popular factors in four segments of the global equity markets: quality, low beta, momentum, size, and value. The interested reader can delve into our analysis in our recent paper, “Revisiting Our ‘Horribly Wrong’ Paper.”
We find that 15 of the 19 factors were trading rich, above historical norms. 9 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. Is it any wonder multi-factor strategies fell short of investors’ expectations?
This is now
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 9 US factors, 7 are now trading cheap relative to history, with 6 of the 7 in the cheapest quintile of the historical range. Only 2 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 5 factors that are trading rich relative to history, only 1 – 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.
A different time calls for a different approach
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.
Disclaimer: Please refer to our disclosures.