For as long as I’ve been running this site, I’ve been writing about and linking to the insights of Rob Arnott, founder of Research Affiliates and inventor of the fundamentally-weighted index. Rob’s an intellectual hero of mine and I’ve seen him speak a bunch of times – but I’d never had the chance to talk with him one-on-one until today. This morning we chatted for almost an hour about everything from smart beta to emerging markets to the current maybe-bubble in US equities.
Below, some highlights from our discussion that I thought were really interesting…
Our discussion begins where it must – on the extreme relative underperformance of all other asset classes versus the S&P 500 over the last few years. Rob says the only question is about when market participants will remember how important it is to be diversified into other asset classes. Diversification always feels bad in a bull market and in a raging bull market (like now), it can become painful – especially when you’re advising other people. In his PIMCO All Asset Fund, Rob’s been overweight emerging markets – both stocks and bonds – primarily because of their relative cheapness versus their US counterparts. It’s a trade that hasn’t “worked” yet, but it’s a position that he feels will shield investors from the dark side of the current reality.
We get into the wisdom (or lack thereof) in cherry-picking out some of the worst EM countries like Russia or the largest of the State-Operated Entities (SOEs) that dominate the EM indices. Rob’s counterpoint is that by eliminating Russia, you’re also eliminating one of the cheapest markets and, by default, overweighting the more expensive ones. This cherry-picking activity kind of messes with the idea of expected returns in the long run if you keep trying to do it.
I mention to Rob how fascinated I was with his piece from the Journal of Portfolio Management last summer* where he took every popular fundamentally-weighted index strategy and showed how it beats the traditional cap-weighted index over the long-term. The best part about his paper was when he then inverted these strategies and showed that – shockingly – their exact opposites also beat the index! I’m still amazed by that but Rob is not. He frames it as a simple matter of removing the market cap weighting from your equation and being able to de-emphasize the biggest, most popular (read: expensive) stocks as a result. If you can do this systematically, you pull ahead of the index through a full cycle (boom and bust) almost every time. The difficulty is that cap-weight is what really gives you rock n’ roll in a bull market – and advisors who are relentlessly judged by the clients against the S&P 500 will struggle to convince them why it’s going to work eventually.
I ask Rob the same question I’ve asked of my friends at O’Shaughnessy Asset Management and WisdomTree and BlackRock etc: What is the difference between factor investing and smart beta? I always get an interesting response to this and Rob’s reply didn’t disappoint. To Research Affiliates, factor investing – which is forty some-odd years old as a practice – is a step in the right direction – but it doesn’t go far enough. While he likes the idea of tilting toward factors, he explains that you’re still starting with a market cap-weighting posture. Whereas smart beta completely breaks the link. In essence, he views fundamentally-weighted indices as an ideal and factor investing as a lighter version – with less efficacy in his view.
He thinks the problem most people have with the concept of “smart beta” has more to do with the marketing itself than with the actual process of owning cheaper or high quality stocks. In that he and I agree. I point out that there is roughly $390 billion currently invested in so-called smart beta index products at the moment but he thinks that’s taking a very liberal definition of the term. To Rob, it’s a much lower number and, more importantly, relative to the total investable asset base of the world ($60 trillion, perhaps), it’s a pebble in the ocean.
One solution for being worried about the current state of elevated valuation in US stocks would be to own RAFI’s fundamental index version – although it’s certainly not a bargain on an absolute basis. While the S&P 500 sells at a CAPE of 27, historically very high, Rob’s index sells for 23. It’s not going to help much but it could cushion the blow on the downside because you’re starting off with lower weightings to bubblier stocks. The fundamentally-weighted versions of EM indices and the like are much cheaper. More on the Research Affiliates fundamental index products at Invesco Powershares here.
Why, I ask, if fundamental indexing is so superior, is there so little money run based on it? He points to the four decades it took for Vanguard to gain mass acceptance despite the fact that their products had been creaming active managers forever. I agree with him here as well. Just because people understand something, that doesn’t mean they will be compelled (or incentivized) to act on it. In many cases, pros have been de-incentivized to act in the interests of their clients. Rob calls it inertia – a resistance to change. I am not afraid to call it cynicism. In either event, he thinks it is inevitable that fundamental indexing will gain more adherents, regardless of the polarization caused by the smart beta label.
In any event, it’s such a thrill and a pleasure to be able to sit down with an investor like Rob Arnott, who’s had such a huge impact on my own thinking over the years. To read the Research Affiliate’s latest paper on smart beta, hit the link below: