Don’t Try to Time Factor Strategies (Part 1)

Investors love to chase performance. But as Morningstar and others have documented, a strong long-term record alone is not predictive of future performance.

Alex Bryan 29 December, 2016 | 10:44
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Investors love to chase performance. But as Morningstar and others have documented, a strong long-term record alone is not predictive of future performance. Many investors have discovered this the hard way, which has helped fuel the growing adoption of index strategies, including strategic-beta funds. These attempt to provide lower-cost, more transparent, and more-consistent exposure to securities with characteristics that have historically been associated with superior performance. But what if the apparent performance edge is not sustainable and investors are just relapsing into counterproductive performance-chasing? These are the provocative questions Rob Arnott and his Research Affiliates colleagues pose in a pair of recent articles, “How Can ‘Smart Beta’ Go Horribly Wrong?”1 and “To Win with ‘Smart Beta’ Ask if the Price is Right.”2

In these research pieces, Arnott and his co-authors argue that when a factor outperforms and investors get more excited about it, it tends to get more expensive. As a result, it is less likely to outperform going forward. The same process works in reverse as factors underperform. In other words, valuations matter, and it is necessary to account for the valuations of each factor to properly set expectations for its future returns. Arnott and his colleagues went one step further and made the bold assertion that much of the return premiums during the past 50 years to the low beta and gross profitability factors were attributable to rising valuations, which are unlikely to persist. (However, they still delivered better risk-adjusted performance, net of valuation changes.)

Using data from 1967 through March 2016, the Research Affiliates team found that as value stocks become cheaper relative to growth stocks, they were more likely to outperform during the next five years. It uncovered a similar inverse relationship between valuations and future performance for the small-cap, illiquidity, investment, and gross profitability factors. This inverse relationship for momentum was weaker in the long term than in the short term. This isn’t surprising because momentum is a high-turnover strategy and its future portfolio often bears little resemblance to its present one.

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About Author

Alex Bryan

Alex Bryan  is the Director of Passive Fund Research with Morningstar.

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