Revisiting Our “Horribly Wrong” Paper: That Was Then, This Is Now

  • Nearly seven years have passed since the publication of our 2016 paper “How Can ‘Smart Beta’ Go Horribly Wrong?” We review factor performance from March 2016 through September 2022, to gauge whether our concerns were correct. They were. Most of the popular factors fell far short of expectations, and those for which we counseled caution in 2016 fared particularly badly.

  • Consider a strategy that has seen its relative valuation multiples soar relative to the market and relative to its own historical valuation norms. Its past returns are artificially inflated by this revaluation, and its future returns may be seriously compromised if there is any mean reversion in its relative valuation levels.

  • Today, we are bullish for the mirror image of the reasons we were cautious in 2016 and 2017. With 11 factors trading in the cheapest quintile of their historical relative valuation, the return prospects of multi-factor investing appear promising over the next several years.

In 2016, we published a controversial paper titled “How Can ‘Smart Beta’ Go Horribly Wrong?”, the first in a series of papers we would publish over the next 18 months on the future of factor investing and other forms of so-called smart beta. Others have whimsically called them our “Horribly Wrong” papers.

Were our cautionary observations correct? Absolutely. Did smart beta go horribly wrong? Yes and no. Almost all variants of smart beta fell far short of artificially inflated expectations. Many failed outright, delivering negative alpha in the subsequent years. The strategies for which we counseled caution mostly fared rather badly.1

Today, the opposite holds true. For many strategies, performance prospects are outstanding. We are bullish now for the mirror image of the reasons we were cautious in 2016 and 2017. Most factors today are trading cheap relative to historical norms. Indeed, most factors are in their cheapest quintile in history.

That Was Then…

In the 2016-17 articles, we showed that all of the popular factors and strategies we tested (hereafter, we use “strategies” to refer to long–short factors and long-only strategies, taken collectively) exhibited a historical pattern of mean reversion in relative valuation, with no exceptions. Because of this, they tended to perform best when their valuation multiples (relative to the market) were abnormally cheap; this typically occurred after a period of lousy performance. They performed worst when they were abnormally expensive, often after a period of outstanding performance.