Improving factor returns through structural factors

Although smart beta funds and factor investing have faded into the background after years of disappointing returns, they are certainly not dead yet. Clearly, fund managers follow a particular style, which is often informed and dependent on the performance of one or more factors. But what if the factors reported in the literature are distorted by constantly changing stock valuations?

If you are a value investor, you obviously want the valuation of your shares to improve. That’s what you’re trying to exploit. But if you’re a momentum or quality investor, changes in valuation aren’t really what you’re looking for. Yes, when the market realizes that a company is highly profitable, it should reward it with a higher valuation. But the fundamental return driver should be the increase in book value and dividends from earnings, not the change in price-to-earnings ratios or price-to-earnings ratios.

What the folks at Research Affiliates did It estimates how much of the reported factor return is due to this change in valuation over time and how much is due to structural risk premia driven by changes in the fundamentals of the factor in question. In fact, they have ignored the change in P/B multiples in the reported factor returns and called what is left the structural component.

Here you see a graph of the structural premium versus the reported premium for a selection of prominent factors and the average of the 14 factors they analyze in the notes. In most cases, valuation changes make a negative contribution, causing the structural premium to be slightly higher than reported in the literature. For the fourteen factors analyzed, the reported average annual factor premium is 4% (between July 1973 and December 2022), but changes in valuations created an average drag of -0.4% per year, reducing real structural factor returns by 4.4% per year

Allocation of factor returns

Source: Arnold et al. (2025)

The question that emerges from this analysis is the ‘so what’ question. After all, you cannot invest in such a way that you only get the structural factor return. You always get the realized return and you cannot ‘hedge’ changes in valuation multiples.

But investors need to build portfolios, and changes in valuation should (in theory) cancel each other out in the long run. The fact that there is a small revaluation return in the graph above shows that this is not necessarily true even for investment periods of thirty years, but that the return contribution of this revaluation effect decreases significantly over time.

So when you build a portfolio, the longer your investment horizon, the less important the revaluation return and the more dominant the structural return. So, if you are a long-term investor, you should get better results if you use the structural factors to estimate the appropriate weights for different factors in a multifactorial portfolio. And that’s exactly what the researchers get in their analysis when they try to build a multifactorial portfolio and compare its performance against different benchmarks.

Optimal weightings for multifactor portfolios

Source: Arnold et al. (2025)