Smart beta funds have failed to live up to investor expectations over the past decade, according to research that has prompted fresh warnings about the hugely popular strategies.

A halfway house between active and passive investing, smart beta has exploded in popularity in the past 10 years as investors search for alpha-like returns combined with the transparency and low costs associated with passive investing.

Global assets in smart beta funds — also known as factor funds for the way they allocate according to factors such as value and momentum — have more than doubled in the past five years from $485bn to $1.1tn, according to Morningstar.

However, research by smart beta pioneer Research Affiliates shows that factor funds’ performance has fallen far short of what they previously advertised to investors.

Research Affiliates’ analysis, which used Bloomberg performance data to simulate investor experience of smart beta funds between 2009 and 2018, found that most of the fund types within Morningstar’s strategic beta classification yielded less than their benchmarks over the period.

Global value funds underperformed by 3.83 per cent and 4.48 per cent over 10 and five years respectively. Funds targeting momentum registered 1.38 per cent and 3.42 per cent losses over the periods.

Meanwhile, US multi-factor funds, which are frequently touted as a diversified way for investors to gain exposure to all factors, lost 1.92 per cent over 10 years and 2.55 per cent over five years.

Vitali Kalesnik, head of equity research at Research Affiliates, said the weak performance demonstrated the limits of smart beta and served as a warning that investors should be wary of hype associated with the strategies.

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“In many cases, investors’ expectations about the magnitude of outperformance were somewhat exaggerated,” said Mr Kalesnik, adding that the practice of backtesting portfolios to simulate future performance was open to manipulation.

“Many investors flocking to [smart beta] were unprepared for the ride,” he said. “They did not realise that factors are prone to crashes and potential prolonged periods of underperformance.”

Most factors tend to perform poorly during bull markets, so the decade-long equity rally is part of the reason for smart beta funds’ underperformance. Value has fared particularly badly as a result of the strength of growth stocks.

“This does not imply that the factor investing strategies are flawed by definition,” said Mr Kalesnik. However, he warned that asset managers and financial advisers had not done enough to explain the risks to retail investors. “It’s not trivial to understand the risk profiles of these strategies. When they are marketed to investors, very infrequently do you hear the salesperson talking about the risks involved.”

Research Affiliates remains an advocate of smart beta investing but has reservations over how the market has evolved. In a paper published this year, the US company said smart beta’s widespread adoption, including by retail investors, meant it warranted closer scrutiny.

Mr Kalesnik said that in a worst-case scenario uneducated investors may abandon smart beta strategies at the wrong time, realising a loss and potentially “undermining the credibility of smart beta investing”.

Lionel Martellini, a professor at France’s Edhec Business School, said: “Smart beta is not a free lunch.

“A well-diversified exposure to rewarded factors will not always outperform. The promise is instead merely that it will provide superior risk-adjusted performance on average across market conditions in exchange for suffering pain in some market conditions.”

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