Forecasting Factor and Smart Beta Returns (Hint: History Is Worse than Useless)

28 Pages Posted: 22 Sep 2017

See all articles by Robert D. Arnott

Robert D. Arnott

Research Affiliates, LLC

Noah Beck

Research Affiliates, LLC

Vitali Kalesnik

Research Affiliates LLC

Date Written: February 2017

Abstract

In a series of papers we published in 2016, we show that relative valuations predict subsequent returns for both factors and smart beta strategies in exactly the same way price matters in stock selection and asset allocation. To many, one surprising revelation in that series is that a number of “smart beta” strategies are expensive today relative to their historical valuations. The fact they are expensive has two uncomfortable implications. The first is that the past success of a smart beta strategy—often only a simulated past performance—is partly a consequence of “revaluation alpha” arising because many of these strategies enjoy a tailwind as they become more expensive. We, as investors, extrapolate that part of the historical alpha at our peril. The second implication is that any mean reversion toward the smart beta strategy’s historical normal relative valuation could transform lofty historical alpha into negative future alpha. As with asset allocation and stock selection, relative valuations can predict the long-term future returns of strategies and factors—not precisely, nor with any meaningful short-term timing efficacy, but well enough to add material value. These findings are robust to variations in valuation metrics, geographies, and time periods used for estimation.

Keywords: smart beta, factors, factor tilts, valuation, alpha forecasting

JEL Classification: G10

Suggested Citation

Arnott, Robert D. and Beck, Noah and Kalesnik, Vitali, Forecasting Factor and Smart Beta Returns (Hint: History Is Worse than Useless) (February 2017). Available at SSRN: https://ssrn.com/abstract=3040953 or http://dx.doi.org/10.2139/ssrn.3040953

Robert D. Arnott

Research Affiliates, LLC ( email )

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Noah Beck

Research Affiliates, LLC ( email )

620 Newport Center Dr
Suite 900
Newport Beach, CA 92660
United States

Vitali Kalesnik (Contact Author)

Research Affiliates LLC ( email )

620 Newport Center Dr
Ste 900
Newport Beach, CA 92660
United States
949-325-8717 (Phone)
949-325-8917 (Fax)

HOME PAGE: http://researchaffiliates.com/index.htm

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