If all investors were rational, markets would be much more stable. There would be no flight-to-safety scenarios, nor real estate and stock market bubbles. History tells us differently.

In theory, stocks, bonds and real estate are all claims on economic growth. Their yield should amount to the same. But it hasn’t. The explanation lies somewhere between investor irrationality and the less than placid history of growth and prosperity.

In any case, the equity risk premium is retrospective, not prospective. It tells us what was, not what will be. Studies of U.S. markets, most going back to 1926, but some going beyond, report a risk premium of around 5%, with the stock market returning around 9%. But there are two caveats. The returns happened over long periods, and 10 years is not a long period— as U.S. equity investors learned after the tech bust in 2000.

Further, the U.S. research on long-term returns tracks a continuous market. But the Second World War disrupted many stock markets now part and parcel of the developed countries’ opportunity set. In consequence, equity risk premia can be discerned, but with far less data than for the U.S. (or for that matter, the rest of the Anglosphere).

Still, as countries modernize and join the global marketplace, one would expect arbitrageurs to homogenize returns across all markets: call it a convergence of investor behaviour.

In such a world, alternative risk premia—smart beta—wouldn’t work. In practice, it shouldn’t work at all, even where it has been most extensively observed: the U.S.

Yet smart beta remains attractive. As well-known passive investor Bill Bernstein said in a recent interview, “The bozos have jumped in with both feet.” But that’s more a comment about beta in general: the equity risk premium.

In indexing theory, bozo investors cancel each other out, letting the wisdom of crowds prevail. For better or worse, that’s a rational expectation, not a reality. Beta, let alone smart beta, won’t disappear anytime soon.

Scot Blythe is a Toronto-based financial writer.
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