The No. 1 question asset owners ask investment strategist Peter Hecht these days is this: What kind of returns should investors expect from smart beta strategies and how do actual returns compare to historical back-tested results?
His answer is sobering: a 58% reduction after correcting back-tested realized average returns for data mining and arbitrage effects.
Smart beta — aka alternative beta, exotic beta, risk factor, style premia and risk premia investing — is “one of the most popular, cutting-edge investment products available today,” but strategies “have a few key features that make the "returns-on-a-prospective-basis' issue unique, interesting and potentially problematic,” said Mr. Hecht, managing director and senior investment strategist at hedge funds-of-funds manager Evanston Capital Management LLC, Evanston Ill., in his latest paper.
Mr. Hecht argues current methods of calculating future returns that don't factor out the impacts of data mining and arbitrage as smart beta strategy details become public likely lead to inflated expected returns going forward in his paper, “Smart Beta, Alternative Beta, Exotic Risk Factor, Style Premia, and Risk Premia Investing: Data Mining, Arbitraged Away, or Here to Stay?”
By identifying unbiased smart beta factors and calculating the arbitrage effect for the 25-year period ended in December 1991 and comparing the returns to the actual investor experience for the following 25 years ended in 2015, Mr. Hecht said his most conservative estimate is a return 58% lower than expected.
Mr. Hecht's paper is available online at https://www.evanstoncap.com/docs/news-and-research/evanston-capital-research—-smart-beta.pdf.