Pitfalls in Smart Beta:

Data Mining, Selection Bias

and Performance Chasing
Rob Arnott

June 8, 2017
Inside ETFs Smart Beta
How Can Smart Beta Go Horribly Wrong?
Watch out for trend-chasing! Valuations Matter
Most investors already practice a form of market timing
unfortunately in the wrong direction by chasing past performance
They fund the success of contrarian investors

Emphasizing factors or strategies that are trading cheap relative to

their own historical norms and deemphasizing the more expensive
factors or strategies can improve performance

Smart beta is becoming synonymous with factor investing

We observe the incredible shrinking factor returns in live assets
Factor tilts do not replicate smart beta strategies. Factor tilts are not
true smart beta

2
Trend Chasing Everywhere Survivorship Bias

Practitioners look for best historical performance.

Academics look for best historical performance.
Asset Owners look for best historical performance.

Problem: Not all factors are robust.

Selection bias and data mining are mistaken for persistent alpha1
Rising valuations are mistaken for persistent alpha2

Harvey, Liu, Zhu (2015); Beck, Hsu, Kalesnik, Kostka (2016).

3
Fama, French (2002); Arnott, Bernstein (2002); Campbell, Shiller (1988); Cochrane (2008).
Alpha Decomposition

Portfolio Return Due to Change Valuation-

+
Alpha in Relative Valuation Adjusted Alpha

Revaluation Alpha Structural Alpha

Alpha due to change in relative valuation

is mean reverting and averaging roughly zero in the long run
contributes significantly to strategy performance in the short run
Short run can mean decades!

Alpha adjusted for change in relative valuation is a good measure of

unconditional expected return of a strategy
4
 Valuation Cycle for Value Factor
Value vs. Growth, United States (July 1968December 2016)
4.00 1.00

B E
2.00 0.50
Relative B Relative
Performance, C D Valuation,*
Value
A Value
vs.
vs.
Growth
1.00 0.25 Growth
A E

Biotech Bubble Global Financial

C Crisis
Nifty Fifty

0.50 Tech Bubble 0.13

1968 1976 1984 1992 2000 2008 2016

Value Performance Relative Valuation

*Based on a blend of four valuation metrics: Price/Book, Price/5yrSales, Price/5yrEarnings, Price/5yrDividends.

5
Source: Research Affiliates, LLC, using data from CRSP and Compustat.
 Factor Valuations Are Predictive of Future Returns
Example: The Value Factor
Value vs. Growth (July 1968December 2016)
30%

15%

Subsequent
Five-Year
Return

0%

-15%
0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45
Relative Valuation (Aggregate)

US Developed EM Median Valuation

Source: Research Affiliates, LLC, using data from CRSP, Compustat, Worldscope, and Datastream. 6
Factor Valuations Are Predictive of Future Returns
Gross Profitability Factor Size Factor
15% 25%
Correlation: -0.78
Subsequent 5-Yr Return

Subsequent 5-Yr Return

Correlation: -0.41 20%
10% t-stat: -2.06** t-stat: -7.53***
15%
5% 10%
0% 5%
-5% 0%
-5%
-10% -10%
-15% -15%
1 1.5 2 2.5 3 3.5 0.2 0.7 1.2
Relative Valuation (aggregate) Relative Valuation (aggregate)

Momentum Factor Low Beta Factor

25% 20%
Correlation: -0.27 Correlation: -0.11
Subsequent 5-Yr Return

Subsequent 5-Yr Return

20%
t-stat: -1.79* t-stat: -0.79
15% 10%
10%
5% 0%
0%
-5% -10%
-10%
-15% -20%
0 2 4 6 0 1 2 3
Relative Valuation (aggregate) Relative Valuation (aggregate)

Long-Term Forecast Near-Term Forecast

Source: Research Affiliates, LLC, using data from CRSP and Compustat. As of December 2016.
7
Two-Tail statistical significance: * = 10% threshold; ** = 5% threshold; *** = 1% threshold.
 What We Saw in June 2016
US US Dev ex US Dev ex US Emerging Markets Emerging Markets
(1967 Mar 2016) (1967 Mar 2016) (1983 Mar 2016) (1983 Mar 2016) (1996 Mar 2016) (1996 Mar 2016)
Aggregate P/B Aggregate P/B Aggregate P/B

8
Legend
Factor Is Expensive
4
Current Valuation

2
Median Valuation
Relative Valuation of Factors

Factor Is Cheap
1

0.5

0.25

0.125

0.0625
Gross Low Small Value Value
Momentum Illiquidity Investment
Profitability Beta Cap (Aggregate) (P/B)

Source: Research Affiliates, LLC, using data from CRSP and Compustat, 1967Mar 2016. The chart was originally published in
8
To Win With Smart Beta Ask if the Price is Right, June 2016, Arnott, Beck, and Kalesnik.
What Happened Afterwards in 2016
Performance of Value-, Low Beta-, Quality-, and Momentum-Oriented Strategies,
JulDec 2016

Performance Relative to the Benchmark Absolute Index Performance

Region Index Jul-Dec Prior Prior Jul-Dec Prior Prior
2016 3 Years 5 Years 2016 3 Years 5 Years
S&P 500 7.8% 39.7% 76.8%
FTSE RAFI US 1000 3.9% -5.3% -2.8% 11.7% 34.4% 74.0%
United States

Russell 1000 Value 2.6% -7.0% -5.6% 10.4% 32.6% 71.2%

S&P 500 Low Volatility -9.6% 9.4% 21.6% -1.7% 49.1% 98.4%
MSCI USA Quality -0.8% 0.8% 1.6% 7.0% 40.5% 78.5%
S&P 500 Momentum -4.2% -3.0% -7.9% 3.6% 36.6% 69.0%
MSCI World 6.8% 22.3% 37.8%
Developed Market

FTSE RAFI Developed 4.1% -5.3% -8.4% 10.9% 17.0% 29.5%

MSCI World Value 3.9% -6.5% -7.2% 10.7% 15.9% 30.7%
S&P Developed Low Volatility -8.7% 9.2% 18.1% -1.9% 31.5% 56.0%
MSCI World Quality -3.3% 10.8% 20.4% 3.5% 33.2% 58.3%
S&P Momentum Developed -5.7% -0.5% 8.5% 1.1% 21.9% 46.3%
MSCI Emerging Markets 4.5% -4.6% -17.5%
Emerging Market

FTSE RAFI Emerging 10.6% -3.1% -7.7% 15.1% -7.7% -25.3%

MSCI Emerging Markets Value 2.5% -4.9% -7.2% 7.0% -9.6% -24.8%
S&P Emerging Markets Low Volatility -7.0% -6.2% 10.7% -2.5% -10.8% -6.8%
MSCI Emerging Markets Quality -4.1% 7.5% 11.5% 0.4% 2.9% -6.0%
S&P Emerging Markets Momentum -3.7% 12.7% 26.2% 0.8% 8.1% 8.7%

Source: Research Affiliates, LLC, using Bloomberg data. 9

Most Investors Are Trend Chasers!

9.78%
9.36% S&P 500
8.81% 8.66% Index
8.38% 8.23%
8.05% 8.97%

6.87% 6.76%

5.22%

All Funds Growth Funds Value Funds Small-Cap Funds Large-Cap Funds

Dollar-Weighted Return Buy-&-Hold Return S&P 500 Index

Source: Hsu, Myers, and Whitby, Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies,
10
Journal of Portfolio Management (Winter 2016).
Most Academics Are Trend Chasers!

Return Degradation Before and After Factor Publication

United States (Jan 1967Aug 2016)

Value Value Low

Annualized Results Momentum Size Illiquidity Profitability Investment Average
(Blend) (B/P) Beta

Year Published 1977 1977 1993 1981 2002 1975 2013 2004

Before Publication 9.8% 9.1% 5.4% 7.0% 2.5% 7.4% 1.2% 3.5% 5.8%

After Publication 2.3% 1.4% 3.7% 0.8% 5.0% 2.1% 5.0% -1.0% 2.4%

Difference -7.5% -7.8% -1.8% -6.2% 2.5% -5.4% 3.8% -4.5% -3.3%

After-Publication Alpha is Not Large!

2.4% is for long-short portfolio 1.2% per side
Thats before trading costs, implementation shortfall and fees
Residual alpha for end customers could easily be zero!

Source: Research Affiliates, LLC, using CRSP/Compustat and Worldscope/Datastream data. 11

Most Product Providers Are Trend Chasers!

Return Degradation Before and After Smart Beta Index Launch

United States (Jan 1967Aug 2016)

Fundamental Equal Low-Vol FTSE RAFI Quality Dividend Risk Maximum

Annualized Results Average
Index Weight Index Low Vol Index Index Efficient Diversification

Year Launched Nov-05 Jan-03 Feb-11 Apr-13 Dec-12 Nov-03 Jan-10 Nov-11

Before Launch 2.0% 1.3% 1.2% 2.2% 0.4% 2.9% 2.7% 1.6% 1.8%

After Launch 0.5% 2.3% 2.1% 0.1% 0.1% 1.3% 0.9% 4.1% 1.4%

Difference -1.5% 1.0% 0.9% -2.1% -0.4% -1.6% -1.9% 2.5% -0.4%

Here, at least, theres some hope

1.4% after launch is not bad, not far below prior simulated results
Again, this is before trading costs, implementation shortfall and fees
But, many of these have low turnover, and most have delivered live
results ahead of benchmark since launch, net of all fees and costs

Source: Research Affiliates, LLC, using CRSP/Compustat and Worldscope/Datastream data. 12

Trend Chasing Is Costly

Performance Characteristics of Trend Chasing and Contrarian Allocations, United States

(Jan 1977Aug 2016)

Smart Beta Strategies Factors

Trend Chasing and Contrarian Strategies Trend Chasing and Contrarian Strategies

Value Add (Ann.) Information Ratio Average Alpha (Ann.) Sharpe Ratio

0.66
6.1%
0.52

0.34 0.33

0.25 2.4%
2.0%
1.5% 1.2% 0.14
1.2%

Equally Weighted Three Best Three Cheapest Equally Three Best Three Cheapest
Smart Beta Performing Smart Smart Beta Weighted Factor Performing Factors Factors
Allocation Beta Strategies Strategies Allocation (1,3,5,10 yr
(1,3,5,10 yr Performance)
Performance)

Source: Research Affiliates, LLC, using CRSP/Compustat and Worldscope/Datastream data. 13

Contrarian Investing Adds Value
Average Mutual Fund Subsequent Three-Year Performance, Sorted by Prior
Three-Year Returns, US Long-Only Equity Funds (Jan 1990Dec 2016)

11.7%

11.0%

10.6%
Subsequent
Three-Year 10.3%
10.2% Average = 10.3%
Average 10.1%
9.9% 10.0%
Annualized 9.8%
9.7%
Return

8.5%
1 2 3 4 5 6 7 8 9 10
Decile Portfolios, Based on Prior Three-Year Returns
1= 10 =
Lowest Decile Top Decile

Source: Research Affiliates, LLC, based on data from Morningstar Direct. 14

 Timing with Valuations Is Not Always a Value Tilt
Allocation of Strategies and Factors Used in the Most and Least Expensive Series,
Relative to Own History, United States (Jan 1977Aug 2016)

Presence of Smart Betas Presence of Factors

Dividend Index Value (Agg)

Fundamental
Value (B/M)
Index

FTSE RAFI Investments

Low Vol

Low-Vol Index Low Beta

Risk Efficient Size

Equal Weight Illiquidity

Maximum
Momentum
Diversification

Quality Index Profitability

1977 1986 1995 2004 2013 1977 1986 1995 2004 2013

Portfolio of Least Expensive Portfolio of Most Expensive

Note: Cheapest and most expensive valuations are computed as a blended average of Five-year Average Earnings-to-Price, Five-year
Average Sales-to-Price, Five-year Average Dividends-to-Price, and most recent Book-to-Price ratios. For each factor/valuation metric
we compare their current valuation relative to long run average valuation. 15
Source: Research Affiliates, LLC, using CRSP/Compustat and Worldscope/Datastream data .
 Research Affiliates Smart Beta Interactive Site
Real Long-Term Expected Return, Relative Valuation, Select Factors
US Factors (as of 12/31/2016) (as of 12/31/2016)
12% 4

2
Expected 5-Year Returns (Ann.)

8%

Relative Valuation
EM Value (Aggregate)
EM Value (P/B)
1
Momentum
4%
Profitability US Value (Aggregate)
0.5

Investment
0% US Value (P/B)
Illiquidity 0.25
Size
Low Beta

-4% 0.125
0% 5% 10% 15% 20% 25%
Volatility

US EM

Source: Research Affiliates, LLC, using CRSP/Compustat and Worldscope/Datastream data. 16

 Research Affiliates Smart Beta Interactive Site
Real Long-Term Expected Return, Relative Valuation,
Net of Transaction Costs, US Smart Select Smart Beta Strategies
Beta Strategies (as of 12/31/2016) (as of 12/31/2016)
12% 4

EM, RAFI Fundamental Index

2
Expected 5-Year Returns (Ann.)

8%

Relative Valuation
1

4%
Quality
Income 0.5
US, RAFI Fundamental Index

0% Value Momentum 0.25

Low Volatility Small Cap

-4% 0.125
0% 5% 10% 15% 20% 25%
Volatility

US EM

Source: Research Affiliates, LLC, using CRSP/Compustat and Worldscope/Datastream data. 17

The Incredible Shrinking
Factor Returns

18
Our Methodology
Our database
All funds from Morningstar Direct survivorship bias-free fund universe
US open-ended long-only active equity funds, with at least two-year
return history from January 1990 to December 2016
Share-class inclusion: A-share, No-load-share, and Institutional-share
We can reverse-engineer the factor returns earned by managers
We first measure mutual funds average factor loadings over time by
regressing fund returns against conventional constructed factor returns.
We then run a cross-sectional regression, of fund returns on fund factor
loadings, to estimate monthly factor returns, as realized by live funds
The slippage in factor returns:
While the conventional factor returns and the factor returns realized by
the managers show ~0.9 correlation, there is often a huge shortfall
19
 LongShort Factor Returns versus Realized Factor
Returns Captured by Managers
Market Size
12% 8%
Market Factor Return Captured

Market Factor Return Captured

Correlation = 0.92 Correlation = 0.96
Slope = 1.01 4% Slope = 1.00
4%
by Managers

by Managers
0%

-4%
-4%

-12% -8%
-12% -8% -4% 0% 4% 8% 12% -8% -4% 0% 4% 8%
Observed Market (Mkt - RFR) Factor Return Observed Size (SMB) Factor Return

Value Momentum
8% 16%
Market Factor Return Captured

Market Factor Return Captured

Correlation = 0.89 Correlation = 0.90
Slope = 0.95 Slope = 0.98
4% 8%
by Managers

by Managers
0% 0%

-4% -8%

-8% -16%
-8% -4% 0% 4% 8% -16% -8% 0% 8% 16%
Observed Value (HML) Factor Return Observed Momentum (UMD) Factor Return

Source: Research Affiliates, LLC, using data from CRSP, Compustat, Morningstar Direct, and the website of Kenneth French.
20
Jannuary 1991 December 2016. Monthly Correlations are shown in all four graphs.
 Factor Slippage Market Factor
Market-Risk Free
Cumulative Returns Cumulative Difference,
Realized Versus Theoretical
$400 $125

$314
$100
Growth of $100 (log scale)

Growth of $100
$200 $205
$75

$50
$100

$25
Shortfall (per ann): -4.2%
t-stat = -3.54
$50 $0
1990 1996 2001 2006 2011 2016 1990 1996 2001 2006 2011 2016

Return Captured by Manager

Theoretical L/S Factor Return

Note: Cumulative returns are compounded using arithmetic returns. 21

 Factor Slippage Size Factor
Small CapLarge Cap
Cumulative Returns Cumulative Difference,
Realized Versus Theoretical
$200 $125
$185
$167
Growth of $100 (log scale)

Growth of $100
$100 $100

Excess (per ann): 0.7%

t-stat = 1.13
$50 $75
1990 1996 2001 2006 2011 2016 1990 1996 2001 2006 2011 2016

Return Captured by Manager

Theoretical L/S Factor Return

Note: Cumulative returns are compounded using arithmetic returns. 22

 Factor Slippage Value Factor
Cumulative Returns Cumulative Difference,
Realized Versus Theoretical
$256 $125

$194
$157
$100
$128
Growth of $100 (log scale)

Growth of $100
$75

$64

$50

$32
$25
Shortfall (per ann): -1.4%
t-stat = -1.38
$16 $0
1990 1996 2001 2006 2011 2016 1990 1996 2001 2006 2011 2016

Return Captured by Manager

Theoretical L/S Factor Return

Note: Cumulative returns are compounded using arithmetic returns. 23

 Factor Slippage Momentum Factor
Cumulative Returns Cumulative Difference,
Realized Versus Theoretical
$400 $125
Shortfall (per ann):- 5.2%
t-stat = -3.43
$100
$247
Growth of $100 (log scale)

Growth of $100
$200
$75

$111 $50
$100

$25

$50 $0
1990 1996 2001 2006 2011 2016 1990 1996 2001 2006 2011 2016

Return Captured by Manager

Theoretical L/S Factor Return

Note: Cumulative returns are compounded using arithmetic returns. 24

 Do Mutual Funds Capture Their Factor Returns? No!
Annualized Factor Returns, US Equity Funds (Jan 1991 Dec 2016)
8.2%

5.7%

4.1%
3.3% 3.6%
2.6%
2.2%

0.4%

Mkt (Mkt-Rf) Size Value Momentum

Theoretical L/S Portfolio Realized Return in Live Portfolio

The returns realized by mutual fund managers can fall short due to:
Transaction costs, fees, bidask spreads and trades that get away
Hard to replicate features of theoretical factor portfolios (usually
constructed ex-post, bringing in data-mining and selection bias)

Source: Research Affiliates, LLC, using data from CRSP, Compustat, Morningstar Direct, and the website of Kenneth French. 25
Similar Slippage in International Equity Funds
Annualized Factor Returns, International Equity Funds (Jan 1991 Dec 2016)

6.3% 6.6%

4.9%

2.3% 2.1%
1.6% 1.6%

Mkt (Mkt-Rf) Size Value Momentum

-0.6%
Theoretical L/S Portfolio Realized Return in Live Portfolio

Source: Research Affiliates, LLC, using data from Worldscope, Datastream, and Morningstar Direct. 26
Why Factor Tilts Are Not
True Smart Beta

27
Factor Tilts = Smart Beta?
The definition of smart beta has been vastly extended
Now, almost anything formulaic, other than a full-market cap-weighted
index, seems to qualify for the smart beta label
Factor tilt and multi-factor strategies are sold as Smart Beta, even
though most of these strategies begin with, and anchor on, cap weighting.
Lets replicate a few generation one smart beta strategies with
factors*:
Fundamental Index
Equally Weighted Index
Minimum Volatility Index
How well do the factor replicated smart beta strategies fare?
much is lost in translation.

*these theoretical factors are Market, SMB, HML, MOM, and BAB. 28
 Early Criticism of Fundamental Index
It Is Repackaged Value
Return Performance and Factor Loadings for Fundamental Index, Equal Weight,
and Minimum Variance Strategies (January 1974June 2016)

Panel A: FamaFrench ThreeFactor Model Plus Momentum

Alpha (Ann.) Market Value Size Momentum R-Sq.

0.97% *** 0.98 *** 0.35 *** -0.08 *** -0.07 *** 97.92%
Fundamental Index
(2.74) (147.47) (33.46) (-8.07) (-10.23)

0.67% 1.03 *** 0.18 *** 0.24 *** -0.02 *** 97.23%
Equal Weight
(1.48) (120.96) (13.78) (19.59) (-2.73)

1.59% ** 0.83 *** 0.16 *** -0.16 *** 0.05 *** 87.38%
Low Volatility US
(2.1) (58.05) (6.97) (-7.61) (3.1)

Panel B: FamaFrench ThreeFactor Model Plus Momentum and BAB Factor

Alpha (Ann.) Market Value Size Momentum BAB R-Sq.

0.67% * 0.98 *** 0.33 *** -0.08 *** -0.08 *** 0.04 *** 98.01%
Fundamental Index
(1.9) (150.06) (29.2) (-8.31) (-11.47) (4.83)

0.38% 1.02 *** 0.16 *** 0.24 *** -0.04 *** 0.04 *** 97.30%
Equal Weight
(0.83) (121.87) (11.25) (19.77) (-3.8) (3.57)

0.51% 0.82 *** 0.08 *** -0.16 *** 0.00 0.16 *** 88.94%
Minimum Variance
(0.71) (61.28) (3.31) (-8.24) (0.26) (8.45)

What about those alphas?

*** Significance at the 1% level, **Significance at the 5% level, * Significance at the 10% level.
29
Source: Research Affiliates, LLC, based on data from CRSP and Compustat.
Factor Replications Miss the Mark
Return Performance of Various Strategies (January 1974June 2016)

Relative to Cap US 1000

Information
Investment Allocation Returns Volatility Sharpe Ratio Value Add Tracking Error
Ratio
Fundamental Index original 12.9% 15.3% 0.53 1.8% 4.3% 0.42
Full Long/Short Factor
12.0% 15.2% 0.47 0.9% 3.4% 0.28
Replicated
Factor Replicated Long Only 12.0% 15.7% 0.46 0.9% 3.2% 0.29

Equal Weight US 1000 original 13.1% 16.9% 0.49 2.0% 4.8% 0.41
Full Long/Short Factor
12.8% 17.4% 0.46 1.7% 5.3% 0.32
Replicated
Factor Replicated Long Only 12.6% 16.8% 0.46 1.5% 5.1% 0.30

Minimum Variance original 12.4% 13.3% 0.57 1.3% 5.7% 0.23

Full Long/Short Factor
12.2% 13.7% 0.54 1.1% 3.0% 0.38
Replicated
Factor Replicated Long Only 12.3% 14.4% 0.52 1.2% 2.6% 0.46

Cap Weight US 1000 11.1% 15.4% 0.41

*these theoretical factors are Market, SMB, HML, MOM, and BAB. 30
When It Comes to Implementation They Miss the
Mark Big Time!
Portfolio Trading Costs, Capacity, Turnover And Leverage (January 1974June 2016)
Ann.
Average Average
Annual Return Long Leg Short Leg Trading Cost Capacity
Long Leg Short Leg
Return Net of Turnover Turnover (bps) ($Bn)
Leverage Leverage
Costs

Fundamental Index original 12.9% 12.9% 11% 1 615 100% 0%

Factor Replication 12.0% 11.7% 57% 15% 32 16 113% 13%

Factor Replication Long Only 12.0% 11.8% 50% 20 25 100% 0%

Equal Weight original 13.1% 13.0% 18% 4 116 100% 0%

Factor Replication 12.8% 12.6% 36% 2% 23 19 104% 1%

Factor Replication Long Only 12.6% 12.4% 65% 20 25 100% 0%

Minimum Variance original 12.4% 12.2% 25% 19 26 100% 0%

Factor Replication 12.2% 11.9% 37% 14% 35 14 111% 11%

Factor Replication Long Only 12.3% 12.1% 75% 23 22 100% 0%

Source: Research Affiliates, LLC, based on data from CRSP and Compustat. 31
Why Factor Tilts Are Not True Smart Beta

Fundamental Index, as one example, is not a repackaged value

Smart beta strategies have factor tilts, but they are much more than this:
Smart beta strategies deliver alpha net of their their Fama-French four-
or fivefactor regressions; factor-replicated strategies do not
Factor loadings show us some of the systematic drivers of return
But, simple factor tilt strategies based on theoretical factors are not the
best way to capture return premiums
Replication portfolios have lower performance, higher turnover, and
smaller capacity
Construction details matter!
Efficient implementation taking into account transaction costs can help
better capture the premia

32
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