How Can “Smart Beta” Go Horribly Wrong?

Research Affiliates

Rob Arnott

Research

14 Pages

Research Affiliates examines how soaring investor demand for smart beta strategies may distort valuations and weaken future returns. The paper argues many factor premiums were driven more by rising prices than structural alpha, raising the possibility that crowded low volatility and quality trades could reverse.

Key Takeaways

Valuation Driven Returns: From 1950 to 1999, 4.1% of annual stock returns came from rising valuations, while the Shiller PE ratio climbed from 10.5x to 44x.
Low Volatility Warning: Low volatility strategies showed a negative 0.38 correlation between valuation levels and subsequent five year excess returns, suggesting expensive defensive trades may disappoint.
Smart Beta Reality Check: Research Affiliates found several smart beta strategies delivered only 0.42% to 2.07% excess returns after stripping out gains from valuation expansion.
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