State Street Global Advisors has a new paper out that seeks to help State Street clients “refine their own strategic asset allocation” especially insofar as their portfolios include smart beta investments, by explaining how State Street forecasts returns, and where the forecasts as to some of the factor returns stand now.

The estimates in this “market commentary” work from the “assessment of current factor valuations and historical return premiums” to derive the likely excess returns of smart beta, which can then simply be added to the forecast of the underlying equity market to produce a total return smart beta forecast.

The authors take the view that “factor valuations are useful in predicting asset class returns over an intermediate horizon,” although over a somewhat longer term they expect return premiums to converge with a historical norm.

Start with Low Volatility

State Street focuses on four factors: value, quality, small size, and low volatility. As to low vol, it ranks all the stocks in the MSCI World (a universe of 1,500) by historical volatility. Then it calculates the median Book/Price ratio of the lowest volatility quintile of stocks, and subtracts that from the median Book/Price ratio of the highest vol quintile. This arithmetic produces a valuation spread for the factor, which State Street has graphed over time.

This spread was very high in the mid 1980s, declined slowly but steadily until 1992, by which time it was well into negative territory. [A negative spread in this context means that the low vol factor is expensive in the context of its own history.] In 1992-93 the spread regained some ground, back into positive territory, but then reversed course again, hitting a nadir in 1997.

After some more such violent zig-zagging through the early years of the new millennium the spread settled down to equilibrium in the barely-negative neighborhood, roughly -0.2 of a standard deviation from the historical norm. It is there still.