Have the Smart Betas become crowded trades? How can we tell?
By these measures, it appears that new investors in Equal-Weighted, Minimum Volatility and Quality run the risk of overpaying for the strategies. They are overpaying by so much, actually, that their entire expected return advantage over the next five years could be wiped out. New investors in Momentum strategies may still have 40bps/year of long term return left after overpaying. High Dividend Yield smart beta investors seem to be paying an attractive price – adding 50bps/year to their expected advantage. The good news for new investors in Value is that very attractive pricing today offers the opportunity to nearly triple their expected long-term return advantage (2.9% vs 1% annually).
What did we look at?
We evaluated six “smart beta” alternatives to a US Large/Mid Cap Cap-weighted index exposure. These were 1) Equal Weighted, 2) Minimum Volatility, 3) Quality, 4) Value, 5) Momentum and 6) High Dividend Yield as defined by MSCI.
How much excess return should we expect from these “smart betas” over the long-term?
Each “smart beta” offers an alternative approach to building a portfolio other than a cap-weighted index. It promises an excess return over time in exchange for tracking error risk. This is no different than an active management proposition. First, for each, we developed an expected tracking error estimate over the next five years. We then made the assumption that each had the same information ratio (expected excess return/unit of tracking error). The resulting expected excess return estimates ranged from 1.0% to 1.6% annually, depending on the “smart beta.”
Are overvalued “smart betas” creating negative valuation returns that detract from their long-term returns?
Investor enthusiasm can take market prices above value. The resulting overvaluation will create a negative source of return for the new investor, as it corrects over time. We refer to this as a negative valuation return. A negative valuation return will detract from an investor’s long-term return, which is compensation for bearing risk over time. Negative valuation returns are observable at the market level, the industry level and certainly at the individual security level. We can therefore also expect them at the “smart beta” level.