Rob Arnott has a dilemma. The founder of quant shop Research Affiliates and smart beta pioneer benefits from going against the grain but is worried about the madness of the crowd right now.
‘As a fund manager, I am always happy when the markets present me with a magnificent opportunity like we are seeing today,’ he says. ‘But as an observer of markets, I care deeply about outcomes and it does distress me when I see so many people chasing fads and thinking they are being scientific.’
The fads he is referring to are multiple, but chief among them is the trend for investors to buy so-called smart beta funds, which are not that smart.
Now, as his Newport Beach-based firm is a provider of smart beta indices, Arnott clearly has skin in the game and something to be gained from bashing other offerings, but equally, he could not be accused of being new to the field nor of lacking academic rigor to his argument.
A fledgling field
Arnott has been obsessed with investment theory since college where he triple-majored at the University of California Santa Barbara in subjects designed to best let him follow his passion, namely applied mathematics, computer science and economics.
‘I designed it to have the foundation for doing computer-based research in investment management,’ he says. ‘It was a fledgling field, the term quant hadn’t even been invented back then.’
This was 1977. He then joined The Boston Company, which was the lowest paid job offer he had but allowed him to dedicate one day a week to his own research.
‘Basically, they said if you want to do a day of research we won’t pay you for it, but we’ll let you do it,’ he laughs.
He set up Research Affiliates in 2002 and after stints teaching at UCLA and editing the Financial Analysts Journal. By 2006, the shop was ‘getting big enough and busy enough ’ that it needed his full attention.
The firm offers smart beta fundamental indices and asset allocation strategies. The busy times Arnott refers to are the start of Research Affiliates’ relationship with Pimco, for which it subadvises more than 20 strategies, most prominently the Pimco All Asset and All Asset All Authority funds.
Arnott spoke to Citywire in his role as chairman of Research Affiliates and not as a Pimco manager and so for compliance reasons could not speak about the performance of these funds.
Arnott's performance in global macro over the past decade
Trying to stop him speaking about smart beta, however, is an impossible task, although some in the industry would perhaps prefer if he did.
Earlier this year Arnott aired his concerns over what he saw as troubling trends in the industry in a white paper called How Can “Smart Beta” Go Horribly Wrong?
The paper argued too many investors were buying strategies tilted toward what was newly expensive rather than what is cheap, lured by past performance derived from nonrecurring rises in valuations.
‘We think it’s reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies,’ it said.
Arnott and his co-authors acknowledged the provocative nature of their argument, especially given their firm’s position as a pioneer in the field.
So what has been the upshot?
‘The short answer: I don’t think the paper has any noticeable impact on product proliferation or on the state of the smart beta arena,’ Arnott says, before adding: ‘It stirred enormous controversy and anger in some quarters and I’ve got to say I found the reaction to be a little surprising and a little amusing. All we were saying was: check the price.
‘You could have a strategy with brilliant performance and if that performance came as consequence of relative valuation for that style soaring, well that’s nonrecurring and you can get yourself in a world of hurt. Whatever is newly expensive is likely to disappoint in the future, is likely to have wonderful past returns, which is why it’s expensive now.
‘People said: “no this is smart beta you don’t have to check the valuations on this.” That’s nuts.’
The paper also criticized those strategies that called themselves smart beta but which retained a link between market capitalization and index weighting.
‘The factor landscape has embraced the term smart beta but I disagree,’ he says. ‘You start with a cap-weighted market and put a tilt on it, so you are still linking the weight to the price and that’s’ the Achilles heel of cap weighting. Why would you want to own more of something after it doubles than before?
‘But I am losing that argument. The market seems to think that anything systematic is smart beta even if its cap weighted and very expensive relative to its historic norms.’
Global asset classes: 10-year expected returns
Value vs growth
Arnott is keen to stress that popular factors such as quality, low volatility and momentum are not bad, just expensive at the moment, especially versus value, which he says is at its cheapest since the tech bubble. Here he finds investors’ behavior perplexing.
‘If a store says 20% off everything, they will be lucky to have the doors intact by the end of the day. If the markets says 20% off, people say get me out of here . We profit by contra trading against crowd behavior but individuals would do well to examine their own behavior and ask, “do I have the courage to buy what has performed badly?”’
And value certainly has performed badly. In Arnott’s own words, for the past eight years, value investing has been a disaster, but he believes the tide turned in February this year and that we are in a new bull market for value versus growth.
‘This is at a time when people are abandoning value and saying, I can ’t stand the pain anymore. Well, they were saying the same thing at the peak of the tech bubble,’ he adds.
‘Don’t bail out of value at its cheapest point since the tech bubble. Good gracious. I’m inclined to think this is a bet I want to mak e on a larger scale, very aggressively.’
The buy of the decade
Another trade he plans to pursue aggressively is emerging markets. Although they have broadly been on a tear in the second half of 2016, even with a post-Trump election win correction, Arnott has been backing the call since January when they were widely out of favor.
This is despite the views of another big name portfolio manager based up the road in Los Angeles: DoubleLine founder Jeffrey Gundlach.
‘Gundlach said in January emerging markets had another 40% to drop and then they would be the buy of the century,’ Arnott says.
‘My thought was: if it’s the buy of the century in the next leg down, then it’s already the buy of the decade. And I want a big portion in it. Maybe it goes down again, but if it does, I want enough dry powder that maybe I double my investment in it.’
He argues that at the start of 2016, emerging markets had a Shiller price-to-earnings ratio of nine, just above that of the US equity market in 1983 – the year the latter began an 18-year bull run.
‘I looked at that and thought, if Gundlach thinks it’s going to go down another 40% he thinks it will go a Shiller P/E of three, and I thought, I’m sorry, I’m not waiting, I want to buy things now,’ Arnott says.
Even the post-Trump election win correction has not dampened his enthusiasm here.
‘Everyone thinks that as Trump is sufficiently xenophobic, he’s going to squash global trade and that will be crushing to the global economies,’ he says. ‘My own view is a little more tempered. His bark is probably a little bit worse than his bite, and I also recognize that those fears are already reflected in prices. That’s a buying opportunity. I like the volatility introduced by political shocks.’