Research Affliates’ Rob Arnott wasn’t a big fan of factor investing back in 2016. Almost all factors, including value, low beta, and momentum, were too expensive at the time and could lead to “a smart beta crash,” he argued seven years ago. But today, Arnott has changed his mind.
That’s because the factors that were trading at historical highs in 2016 have come down to earth. In a recent paper, Arnott studied the performance of 19 factors worldwide and found that 11 of them are trading in the cheapest quintile of their historical valuations. They include low beta, momentum, size, and value factors for U.S. large-cap stocks, quality and momentum factors for U.S. small-cap, momentum and value factors for developed market stocks, and low beta, momentum, and value factors for emerging market stocks.
“Factor investing is finally back... People should pursue it,” Arnott told II in an interview.
In 2016, Arnott’s prediction of a smart beta crash stirred heated debates in the investment community. The most notable response came from AQR’s co-founder, Cliff Asness, who argued that diversification, not timing, is the best way to achieve returns through factor investing.
Arnott said his arguments in 2016 have proved to be valid concerns. Factor returns have been subject to a historical pattern of mean reversion, he said, which suggests that stocks with good past performance tend to trend downward in the future, and vice versa.
“We observe a clear link between cheapness relative to history and subsequent factor performance,” Arnott wrote in the paper. “For any given year, the relationship is weak, but over longer spans, it is surprisingly strong.”
Take the period of March 2016 to September 2022, for example. For each of the 19 factors, the quintile with the lowest relative valuation in 2016 beat the quintile with the highest by an average of 5.7 percent per annum in the following six and a half years, according to RA. That’s a total outperformance of 37 percent.
Since most factors are cheap now, Arnott suggested investors take a multi-factor approach to get exposed to a diversified set of stocks. Being more selective would have worked better in a year like 2020 when factor performance was more polarized, he added. For example, at the end of August 2020, the value factor in all regions was trading far below the lowest quintile of its relative historical valuation, while the momentum factor was trading at a significant premium.
“We thought, at the time, picking factors would be massively profitable. And it was,” Arnott said. “Today, it’s a more nuanced situation where most factors are trading cheap, so multi-factor [strategies] look more interesting.”
“We cannot see the future. But if the relationship between relative valuation and performance is as powerful over the next few years as it was since 2016-17, the 11 factors trading in the cheapest quintile of historical relative valuation should beat the five that are trading rich by perhaps 1000 basis points over the next five years,” Arnott wrote. “Now appears to be a particularly promising time to embrace multi-factor investing.”