New paper suggests some managers are advertising historical returns that are ‘too good to be true’
For advisors and investors seeking a happy medium between active strategies and plain-vanilla passives, smart-beta products may seem like an attractive option. But when it comes to the performance claims that such products come with, a measure of caution may be necessary.
According to a new paper from smart-beta fund manager Research Affiliates, some rival factor strategy providers are using backtests to claim unrealistic results.
As reported by Institutional Investor, such backtests were being used to claim annualized excess returns of up to 4% over the last 10 years without underperforming during any calendar year. But according to Research Affiliates’ head of client strategies John West and senior researcher Alex Pickard, those results are unrealistic.
“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,” the co-authors wrote.
Drawing from Morningstar’s mutual fund database, the two analysed the historical return records of over 4,400 funds operating between 1979 and 2018. Aside from confirming that most mutual funds underperform the market, they found that outperformers tend to subsequently underperform.
“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,” they said. “But factors and asset classes inevitably undergo periods of underperformance, and so do the funds exposed to them.”
They found that some 17% of mutual funds in the sample yielded three-year annualized returns topping 4% at some point during their lifetime, but less than 4% were able to consistently outperform. As for the claim of 4% average annual excess return over a 10-year period with no calendar years of underperformance, the two could not find any fund from the thousands in their sample that managed to achieve it.
“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,” West and Pickard said.
A more realistic expectation from the “best” smart-beta strategies, they said, would be for 1% to 2% in annualized-10 year excess returns, net of transaction costs. As for consistency of performance, they said even long-term outperformers are likely to earn excess returns in just five or six years out of every 10.
“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,” they said.
