Smart Beta Managers Are Boasting ‘Utterly Implausible’ Returns, Research Affiliates Says

Fund managers are using backtests to claim their strategies have delivered outperformance that, according to Research Affiliates, no asset manager has ever exhibited.

Illustration by II

Illustration by II

Some smart beta managers are advertising historical returns that are “too good to be true,” according to a new paper from Research Affiliates.

The smart beta shop argued that rival factor strategy providers are using backtests to claim that their strategies have delivered annualized excess returns as high as 4 percent over the last ten years without underperforming during any calendar year — results that are unrealistic, according to head of client strategies John West and senior researcher Alex Pickard, who authored the paper.

“The confluence of shorter time horizons, increased competition, and recent underperformance may well have led to smart beta backtests ‘jumping the shark,’ that is, reporting utterly implausible return outcomes,” they wrote. As West and Pickard noted, such performance claims “definitely get attention” – but they do not accurately reflect the behavior of factor-based strategies.

Using Morningstar’s mutual fund database, the Research Affiliates duo analyzed actual historical returns for 4,463 funds operating between 1979 and 2018. Beyond the “self-evident and well-trodden” result that most mutual funds underperform the market, West and Pickard also found that outperformers tend to subsequently underperform.

“Heroic outperformance generally does not endure as market cycles progress,” they wrote. “When the value factor does well, most value funds do well, and when low volatility is the factor du jour, low-vol funds outperform, and so on. But factors and asset classes inevitably undergo periods of underperformance, and so do the funds exposed to them.”


While about 17 percent of the mutual funds in the sample produced three-year annualized returns above 4 percent at some point during their lifetime, the research showed that less than 4 percent managed to outperform consistently. And as for the “jump-the-shark claim” — that a strategy had delivered a 4 percent average annual excess return over a ten year period that included no calendar years of underperformance — West and Pickard found that not one of the nearly 4,500 mutual funds in their sample had achieved such a feat.

“In effect, any smart beta vendor who suggests this is a reasonable expectation is laying claim to skill that no asset manager has ever exhibited before — including themselves if they have a live 10-year history!” they wrote.

Based on their research, West and Pickard said the “best” smart beta strategies would more realistically deliver 1 to 2 percent in annualized 10-year excess returns, net of transaction costs. And even long-term outperformers would likely only earn excess returns in five or six years out of every ten, according to the paper.

“Backtests, especially those optimized to maximize the backtest results… may create the illusion of seemingly massive excess returns and limited to few if any bouts of underperformance,” West and Pickard wrote. “A long-term survey of live mutual fund returns reveals a very different picture.”