Smart beta and factor-based strategies have become investment darlings. But are investors being smart about how they assess these strategies? In the
following Q&A, Research Affiliates Chairman Robert Arnott and CIO Christopher Brightman discuss where investors can go wrong, and how the PIMCO RAE
Fundamental strategies’ contrarian approach may provide benefits.
Q: More than 70% of asset owners are using or actively evaluating smart beta strategies in their portfolios, according to FTSE Russell’s 2016 global
survey on smart beta1. Based on your research findings, where might investors be going wrong when evaluating these strategies?
In at least one key way, quant investing is no different from any other form of investing: Performance-chasing often leads to lousy results. With the
soaring popularity of smart beta strategies, we see lots of investors flocking to whatever strategies have the best three-, five- and 10-year performance.
It’s so easy to mistake brilliant past returns for structural alpha, falling prey to the seduction of an “alpha mirage.” While it’s convenient to turn a
blind eye to the current valuation levels of the hottest new strategies, we owe it to ourselves to ask whether the price is right. Is the strategy trading cheaper or richer than historical norms? How do we more reliably gauge an investment’s future return prospects? We ask these questions when assessing stocks, sectors and asset classes. Why wouldn’t the same apply to factor-based and smart beta strategies?
In February, Research Affiliates published a controversial paper asking “How Can ‘Smart Beta’ Go Horribly Wrong?” Well, if you look at 10 so-called “smart
beta” strategies and pick the one with the best 10-year record, you’re likely to be buying at a peak. If you think you’re going to get a 4% alpha, and you
wind up with 4% underperformance, yikes! That’s smart beta going horribly wrong. In that paper, we showed that while valuations may not provide
clairvoyance on picking peaks or troughs of relative performance, they are generally helpful in trying to project future returns2. Building upon our initial research, we broadened our study to confirm the robustness of our findings. For almost all the factor and smart beta strategies we studied, our latest research demonstrates that the relative predictive relationship between starting valuations and subsequent returns is strong over
horizons shorter than five years, using an aggregate of four valuation measures3. This is powerful evidence that valuations matter – albeit with some measure of noise and uncertainty!
Before delving into our analysis, let’s first consider the risks that arise when we ignore valuations and blindly accept the illusion of high past alpha. By dismissing starting valuations, and focusing on strategies with the best past performance, we invest in strategies that are trading at historical highs. This does more than create implausible expectations; if realized returns fall short and our expectations are dashed, we may also be tempted to switch strategies, often at a substantial cost. The recent proliferation of smart beta products invites us to chase the newest, most popular strategies. And performance-chasing – the underlying source of many investors’ travails – may ultimately be value-destroying.
In one of our more noteworthy findings, we observed that some popular strategies’ historical success, even over a half-century, is an “alpha mirage,” attributable mainly – and in some cases, entirely – to rising relative valuations. Over this full-sample period, all U.S. factors had positive performance. The picture changes after netting out the effects of changing valuations on past performance. Net of rising valuations, the value added by low beta and quality (gross profitability) largely disappears. We shouldn’t be surprised. Why should we earn a larger risk premium if our portfolio is less risky (with lower beta) or of higher quality (with high profit margins)? The historical premiums on low beta, higher quality and the perception of safety largely reflect the elevation in valuation multiples – not structural alpha.
Putting our findings into a global context, where are factor valuations trading today relative to their respective histories? A glance at the chart below can tell us a lot. Consider the rightmost vertical line on the chart: The bottom legend tells us that this line is for the “value factor” (based on the price-to-book value ratio4); the top legend tells us that this line is for the value in emerging markets (with relative valuation again based on price to book). If we look at the scale on the far left, we see that this rightmost vertical line runs from roughly 0.1 to 0.25. This means that the value portfolio historically ranges between 10% and 25%, as expensive as the growth portfolio, based on price-to-book ratios. Put another way, the market pays anywhere from four to 10 times as much for growth stocks as for value stocks. The green arrow overlaid on that same graph runs from 0.2 to 0.1. This means that historically, value stocks are priced at an average 20% of the price-to-book ratio of growth stocks, but they are now priced at 10% of the valuation multiple for growth. So value in emerging markets is trading at about half its historical norm.
We repeated this analysis 48 times; for each of eight “risk factors,” based on two different valuation measures (the price-to-book value and a blend of four valuation multiples), and in three different markets: the U.S., EAFE (Europe, Australasia and Far East), and emerging markets. To cut to the chase, many popular factors and smart beta factors are trading quite rich relative to their historical valuations. And if a strategy is trading rich, we can say two things with confidence: It’s probably got terrific past performance, and it’ll probably be disappointing in the future. If a strategy – like emerging markets value – is trading in the cheapest historical decile, we can confidently say the opposite: It’s probably got horrible past performance, and it’ll probably be a much better performer in the future (time will tell).
Momentum and low beta are trading expensive to very expensive when compared with historical norms. Where is the “smart beta” money pouring? Into momentum and low volatility strategies. Ouch; some of these strategies might not be “smart” beta! Others are more mixed. Small cap is cheap in the U.S. and richly priced elsewhere. Quality (profitability) is somewhere between fair and rich in the U.S. (depending on how we measure valuation), very expensive in EAFE and fairly priced in emerging markets. Illiquidity and small cap are fair – even a little cheap – in the U.S. and expensive everywhere else.
Only the value factor seems reliably cheap: a little cheap in EAFE markets, moderately cheap in the U.S. and extraordinarily cheap in emerging markets. It should be no surprise, given the historical cheapness of value relative to growth around the world, that value has been a big disappointment for investors in the past decade. And it should be no surprise – for the valuation-aware investor! – if value is the big winner in the years ahead.
If in fact value does lead the market, that would bode well for PIMCO’s RAE strategies. I can’t wait to see how it fares in the coming five to 10 years!
What can we do with this information? Let’s look beyond the seduction of brilliant recent back-tests and ask what has driven that performance. If it comes from rising valuations, watch out! Relying on rising valuations to continue supporting performance – when valuations are already elevated – is a recipe for disaster. It’s worth asking: Are we adding some of the popular new smart beta factors to our portfolios to diversify? Or is this just “return-chasing” in disguise, which we know is often ultimately value-destroying? A rethinking may be in order.
Q: How is Research Affiliates’ research incorporated into the PIMCO RAE Fundamental strategies?
Christopher Brightman: Today, many are aware of the accelerating flows out of traditional active equity management and into smart beta. Fewer may be aware that PIMCO was way
ahead of this trend: On 30 June 2005, PIMCO launched the first product to adopt Research Affiliates’ Fundamental Index research, PIMCO RAE Fundamental
PLUS. PIMCO followed this product launch with related products in emerging markets, international markets, small companies and long-short low-beta and
In PIMCO’s RAE strategies, we apply an evolving approach to active positioning over the base provided by our Fundamental Index portfolio. While PIMCO RAE
Fundamental strategies remain systematic, the methodologies are not static. They continually evolve in pursuit of excess returns, embracing new insights
that emerge from our ongoing research. To illustrate this evolution, I highlight below two of the more important enhancements to RAE: adjusting for
companies’ financial health, and applying stock price momentum.
Systematic value strategies are prone to buying cheap but unhealthy companies, or “value traps.” Firms’ margins and profits will erode if they fail to
invest in the technology and brands necessary to build (and defend) economic moats around their businesses. Some companies have crushing debt burdens,
transferring most of the worth of their business to bondholders. Others overstate their economic profits through creative, or even outright fraudulent,
accounting. We seek to identify and avoid these firms by looking at measures of corporate health that have empirically predicted earnings-per-share growth,
financial distress and restatements of past earnings, thus helping us to avoid value traps.5
Simple contrarian rebalancing runs the risk of buying cheap securities too soon while their market prices are still falling. To avoid trying to “catch a
falling knife” by fighting price trends, we measure stock price momentum. When a healthy company has become cheap enough to add or to increase our
position, but its stock price is still falling, we generally wait to acquire it or add to our position more gradually. When a company has become so
expensive that we wish to sell it or reduce its position, but its stock price is still soaring, we tend to sell more gradually.6 With these approaches, we seek to avoid both selling too soon and buying “falling knives.”
In our latest research, which Rob discusses above, we found that starting valuations may predict future returns of equity factors. PIMCO RAE Fundamental
strategies already incorporate dynamic factor exposures through systematic rebalancing. Our latest research provides additional support and explanation for
why such contrarian trading can create a persistent source of excess return.
We are now exploring how this new research about factor valuation may be further applied to RAE strategies. To be sure, we do not intend to make drastic
changes or rapidly churn positions by rotating from one factor to another. Yet we intend to employ a systematic process that more actively manages factor
exposures, favoring the cheapest and avoiding the more expensive, while still delivering broadly diversified, economically representative portfolios.
True to our name, we place research at the forefront of our mission. When we discover robust new ways to potentially increase expected excess returns, we
apply these insights in an effort to improve our strategies for the benefit of investors. Accordingly, you should expect us, at some point, to apply our
latest research on factor valuation to the continually evolving PIMCO RAE Fundamental strategies.