The Dangers of Trend Chasing--and What to Avoid Today

Chris Brightman, chief investment officer from Research Affiliates, took the stage at the 2017 Morningstar ETF Conference to discuss traps that those investing in factor strategies fall into.

The biggest pitfall?

"Buying things that are popular because they've done well and gone up the past three, five years," revealed Brightman. "This performance chasing is everywhere we look."

With factor- or style-based investing, when the factor is purchased has an impact on subsequent returns.

A research paper from Research Affiliates published last year, "How Can Smart Beta Can Go Horribly Wrong," illustrates historical instances of performance chasing.

Take value investing. The "value effect" was identified in the late 1970s, during a period of tremendous outperformance in the style; value stocks at the time were overpriced. They soon went on to underperform.

Brightman noted that by the time a factor is written about and products are created around it, that factor has already enjoyed success.

"Nobody comes and says, 'This theme or sector has been doing horribly; let's launch new product on that,'" quipped Brightman. "Be careful about grabbing that shiny new thing."

When relative valuations for a particular factor are expensive, returns of that style going forward lag. According to Brightman, that holds true in the U.S. market, and in international and emerging markets, too.

In a nutshell: factor valuations are predictive of future returns.

To improve their outcomes, investors should fight against the tendency of what has worked in the past, advised Brightman.

So what factor or investment style is most overpriced today? Low-volatility strategies.

"I would discourage you from looking from recent performance of low volatility strategies and extrapolating that into the future," he told the crowd.

Valuation isn't only thing Research Affiliates looks at when considering future performance of a given factor. The organization also considers momentum.

“The bad news for low volatility strategies is, they’re not only expensive, but they’re starting to underperform. Not something you want to jump into.”