Have the Smart Betas become crowded trades? How can we tell?
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.
Comparing today’s “Smart Beta” prices with their expected central tendencies indicates that Equal Weighted, Minimum Volatility, Quality and Momentum are overvalued. High Dividend Yield is near neutrally priced and Value is undervalued. Based on expected correction rates over the next five years, negative valuation returns entirely eliminate long-term returns for Equal Weighted, Minimum Volatility and Quality. Negative valuation return in Momentum eliminates all but 40 bps of return. For High Dividend Yield, its small overvaluation reduces return by only 20 bps. Conversely, the positive valuation return of Value actually adds an annual 140 bps above its long-term 100 bps expected excess return.