Smart- or strategic-beta exchange traded funds that track alternative or customized indices have been a popular way to gain diversified exposure to the equities market. However, the recent surge is making some of these smart-beta strategies pricey.
Rob Arnott, founder of Research Affiliates and father of fundamental indexing, warns of a potential bubble or possible crash in the smart-beta segment, pointing to stretched valuations and elevated price-to-earning ratios among some smart-beta strategies.
“Money has been pouring into low-vol strategies, high-quality strategies, momentum strategies, and we knew that these were trading a little rich relative to history so we wanted to investigate that and we found, lo and behold, [A], yes, they’re trading rich relative to history, and [B], how rich they’re trading is predictive of how well they’ll work in the future for the patient investor,” Arnott told Morningstar.
Arnott cautioned that current prices suggest momentum is a little rich, which may cause the factor to add less value than in the past. Low-beta is trading at rich valuations, near the top decile of historical multiples. Lastly, low-volatility is also trading at a little rich relative to history.
Investors, though, can’t seem to get enough of these alternative strategies. For instance, the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), which selects stocks based on variances and correlations along with other risk factors, has been among the most popular ETFs of 2016, attracting almost $5.6 billion in net inflows year-to-date. However, USMV is showing a 21.1 price-to-earnings and a 3.2 price-to-book, compared to the S&P 500’s 18.1 P/E and 2.5 P/B.[related_stories]
“If what you want to diversify into is expensive, at least average in over a course of a few years or maybe just defer it a year or two and see how the valuation looks then,” Arnott said. “So all we said was valuation matters.”
Related: Smart-Beta ETFs Take Center Stage
Moreover, Arnott’s research has also found that valuations metrics on smart-beta international market strategies are also revealing similar patterns.
“Several of these so-called smart beta ideas are trading rich, they’re liable to disappoint,” Arnott said. “If somebody buys something that has outperformed by 5% a year for the last decade, they’re expecting it to outperform by 5% a year. Well, if it outperformed just by dint of getting more expensive, watch out – it may mean-revert and give you a negative alpha, that’s what I meant by smart beta going horribly wrong.”
For more information on alternative index-based strategies, visit our smart-beta category.