Long-Term Smart Beta Forecasts: December 2016

Published 31-Dec-2016

We advocate using Smart Beta investments as a means to potentially boost returns, increase transparency and manage risk, while keeping costs in check. Although many investors have embraced Smart Beta, few have spent time developing a method to forecast their returns. We hope and trust that our clients will find this analysis helpful as they refine their own strategic asset allocations.

Our long-term forecasts are forward-looking estimates of excess return generated through an assessment of current factor valuations and historical return premiums. These excess return expectations can then be added to our total return forecasts of the underlying equity market to formulate total return Smart Beta forecasts. We find that factor valuations are useful in predicting asset class returns over an intermediate horizon, and over the long term we expect that return premiums will converge to a historical norm.

We focus on the following four factors: Value, Quality, Small Size, and Low Volatility, and in each case our universe is the MSCI World Index.

The starting point for our Smart Beta forecasts is an estimate of the current valuation of each underlying factor. We use the Book/Price ratio to estimate how attractive or expensive each factor is, comparing it to its own history. Figure 1 shows these spreads over time for each factor. To illustrate this point, consider the bottom right chart which focuses on Low Volatilty.

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