A flippant, fearless, and fundamental countdown of big money investing.

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#35 Factor Investing

A Factor Flap

In February, Research Affiliates’ CEO Rob Arnott published an article: “How Can ‘Smart Beta’ Go Horribly Wrong?”

It was a surprising question from the godfather of smart beta. According to Arnott and his team, many smart beta strategies outperformed the market thanks to underlying stocks’ rising valuations. 

“Factor returns, net of changes in valuation levels, are much lower than recent performance suggests,” Arnott wrote. “Much of the historical value-add—in some cases, all!—has come primarily from the ‘alpha mirage’ of rising valuations.” 

Performance chasers exacerbate this “mirage” by bidding up previous winners, Research Affiliates continued. But what goes up must come down. Mean reversion to historical valuation norms will cause smart beta’s “crash,” the firm warned—it’s just a matter when. 

“We are creatures of habit,” Arnott tells CIO. “Quants are trained to look at historical performance. But now we are challenging the orthodoxy. As more institutional clients look into multi-factor strategies, the risk of this ‘crash’ can become even larger.”

As Arnott expected, his views met with contention.

AQR’s leader Cliff Asness penned his own paper and argued timing smart beta strategies based on valuations “should be done in very small doses, if at all. Factor timing is very tempting and, unfortunately, very difficult to do well.” Plus, current value spreads on the most popular factors are “within historic ranges”—not a sign of extreme factor crowding. 

“Invest in [factors] if you believe in them for the long term and be prepared to survive, not miraculously time, these events sticking with your long-term plan,” Asness wrote. “If you time the factors, and I don’t rule it out completely, make sure you only ‘sin a little.’” 

Asness vs. Arnott—game on. 

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