Why Now Is the Wrong Time to Buy Smart Beta

Research Affiliates argues that factor valuations are expensive relative to history.

The value factor is the only form of smart beta currently trading at an attractive valuation, according to Research Affiliates.

“Valuations of many of the most popular factors and smart beta strategies are well above historical norms.”Pricing of factor indexes relative to history matters to investors “every bit as much as they matter when choosing managers, funds, and individual stocks,” wrote Chairman Rob Arnott, Quantitative Researcher Noah Beck, and Head of Equity Research Vitali Kalesnik.

“Today, valuations of many of the most popular factors and smart beta strategies are well above historical norms,” the authors stated, citing their own analysis of historical valuations of eight factor indexes and eight strategies. “We have demonstrated that these high valuations are indicative of lower future returns, even if they are not able to provide any prescience on picking peaks or troughs.”

Value-tilted strategies are currently unpopular with investors and as such are “considerably cheaper than historical norms,” the authors wrote.

However, momentum, illiquidity, and low-beta strategies are all trading near their historic peak valuations, Research Affiliates’ analysis found. Equal-weighted and quality indexes are also near all-time highs outside of the US markets.

These are among the factors attracting the most money from investors, Arnott, Beck, and Kalesnik said, which they argued was “dangerous.”

In addition, the authors warned against reading too much into their findings.

“We would offer a word of caution to those who wish to use these findings to aggressively time strategies,” Arnott, Back, and Kalesnik wrote. “Timing strategies leads to greater concentration of risk, so lacks diversification. A noisy signal and weak ability to diversify is a recipe for disappointment.”

Read the Research Affiliates paper, “To Win With Smart Beta, Ask If the Price Is Right.”

Related: The Hidden Costs of Passive Investing & Is It Too Late for Institutions To Be Contrarian?