Focusing on current valuations relative to a strategy’s or factor’s history, rather than its historical performance,
enables investors to better assess the potential for future excess returns.
Logically, investors have a better chance of generating a premium if they can eventually sell assets at a higher price than those prevailing at the time of purchase. Yet many investors fail to link the initial valuations of assets and factors to forward-looking return prospects and thus engage in performance chasing. The result is exactly the opposite of what investors wish to achieve—selling low and buying high! At RAFI Indices and our sister company, Research Affiliates, we endeavor to reverse this behavior and encourage investors to focus on current valuations relative to a strategy’s or factor’s history rather than historical performance. In doing so, an investor is better able to assess the potential for future excess returns.
Research Affiliates, our sister company, has published a number of articles summarizing our views on valuations. The Research Affiliates Smart Beta Interactive tool is also an excellent resource for investors in researching valuations across a number of factors and smart beta strategies.
Big Market Delusion: Electric Vehicles
A “big market”—opened through innovation or disruption, such as the newly beloved electric vehicles market—lures investors to enthusiastically push up prices of all firms in the industry as if each will be a major winner. But some will fail. Pricing each company’s stock without regard to this fact is the “big market delusion.”
How COVID-19 Vaccines and Brexit Create the Trade of the 2020s
In late 2020, UK stocks, notably UK value, hit very cheap levels relative to value stocks in other developed economies. The final Brexit deal and rapid rates of UK COVID vaccination are the tailwinds to a vigorous bounce back in UK stocks, in particular UK value stocks, making this sector of the market a “trade of the decade.”
Tesla, the Largest-Cap Stock Ever to Enter S&P 500: A Buy Signal or a Bubble?
On December 21, 2020, Tesla will be the largest company ever to enter the S&P 500 Index. Tesla’s skyhigh valuation, which meets our real-time definition of a bubble, conforms to the observation that market-cap-weighted indices buy high and sell low—the antithesis of prudent investing.
Value in Recessions and Recoveries
Recessionary periods create risks and opportunities for value investors. Historically, value outperforms the market during downturns that follow the bursting of a bubble and does relatively worse versus the market in downturns caused by a shock to fundamentals. In recoveries, value (along with quality and size) has strongly outperformed the market as uncertainty around the crisis resolves.
and Smart Beta Returns
Understanding the role relative valuations play in factor investing and smart beta strategies is important. Putting that knowledge into practice in the real world of asset management is critical. We show how valuations can be applied in forecasting factor and smart beta returns.
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