Rob Arnott is Chairman and CEO of Research Affiliates, LLC and a pioneer in asset allocation techniques and smart beta investing, especially fundamentally-weighted indexes and strategies. He is a former Chairman of First Quadrant, and has published over 100 articles. He edited the Financial Analysts Journal from 2002 to 2006, and received the William F Sharpe Lifetime Achievement Award in 2013.
We first met in 2007 when I was responsible for alliances at Colonial First State, and we brought fundamental indexing (sometimes called ‘RAFI’) to Australia with the establishment of Realindex Investments, which now manages about $10 billion. An ASX-listed RAFI fund is also offered in ETF form by BetaShares.
Smart beta and fundamental indexing
Smart beta investment strategies are now so common that it’s hard to believe that only a decade ago, they were considered little more than a quirky idea. The first fund established in the US using fundamental indexing is about to celebrate its 10th anniversary, and after the first, other managed funds and ETFs were quickly rolled out across the world. So with all these ‘many happy returns’ coming up soon, it was a good time to ask where it all started.
“I’d long had a view that cap weighted investing was peculiar. The more expensive a company becomes, the bigger its weight in the index. It tends to put most money into companies that are popular, that have high multiples, that have a strong momentum. Why should we earn a stronger equity risk premium on those companies? I thought we needed an index based on sales or book value, but I never pursued it.”
“Then in the aftermath of the tech boom in 2001, George Keane was sitting on the Board of the State of New York, and was horrified because they had a large chunk in an S&P500 index fund, which had 4% of its money in Cisco, a company priced at about $25 million per employee, a stupendous valuation. Could a company with 25,000 employees be worth that? It has to achieve some remarkable things. He watched in horror as these stratospheric tech valuations came back down to earth, so he approached a few people to talk about a better way to index. He was thinking something like a mid-cap value, but I thought, instead of looking for niche categories, maybe we ought to revisit the way we index. So we tested sales weighting, using the 500 largest companies with investment weighted by sales. I was stunned that going back 30 years, it beat the S&P500 by 2.5% a year. I realised we were on to something big.”
Arnott then tested using index weightings based on profits, book value, dividends, even the number of employees, and they all outperformed cap weighted indexing over long periods. He argues it is because they sever the link with price. If you weight by fundamentals you are achieving economic representation of the broad macro economy. He tested it for 23 countries and found it worked in all but two of them.
Arnott published the results, but initially, the antipathy of academics and the indexing community was palpable. The lack of academic curiosity in particular took him by surprise, and defending their turf, there was animosity from cap weighting businesses. He now believes the notion that it adds value relative to cap weighting is accepted in some circles as obvious, although critics say it’s just another form of active management and is not really indexing.
He is happy with that. “Absolutely they say that, and relative to cap weighting, it’s an active strategy. I like to turn it around. Relative to the macro economy, fundamental indexing is neutral, cap weighting is active. It depends how you see the world. The market is making all kinds of wild bets. It’s making a huge bet for Twitter and a huge bet against British Petroleum.”
Tactical asset allocation and mean reversion
Arnott is also portfolio manager for PIMCO’s All Asset Fund. In this role, he makes tactical allocation decisions across dozens of asset categories, but how does he allocate?
“The world has a lot of asset classes to choose from. The notion of picking market peaks and troughs is naïve, nobody can do it. In the long run, valuation matters tremendously, but in the short run, the flow of capital matters more. The flow of capital is profoundly difficult to anticipate, and central bank interventions create disruptions to market valuations. For those who are patient and contrarian and willing to do what’s uncomfortable, the rewards can be great.
“Suppose you have a company in your portfolio that is recognised as a market leader all over the world, no serious impediments to its growth, the third largest market capitalisation on the planet, which implies it will be the third largest source of profits in the world. It’s called Google. Then we suggest you should get rid of it and switch to a basket of Ukrainian bank stocks, some of which could go to zero. Is a fund manager who does that likely to be applauded or fired? But if you did 20 trades of that sort, collectively they’d probably do well. It’s uncomfortable, but markets don’t reward comfort.”
Arnott is highly systematic. The more valuations move away from historic norms, the more comfortable he is in taking a larger position. The portfolio is not switched straight into a large position but a process of averaging in commences based on valuation signals. Over time, the position is expected to benefit as prices revert to the mean.
“For example, the Schiller valuation of US stocks today is 26 times earnings, the Schiller for Emerging Markets is 15 times earnings. Well, people are scared of EM, and the US is a haven. There’s a flight to safety and the US$ is strong, while there are many political problems in EM economies. OK, I get all of that. But the valuations are better in EM, and based on fundamentals, the earnings multiple is only 11.”
Arnott also writes and speaks widely on demographic change, especially the aging population and lack of tax revenues to pay for services such as health and pensions. He believes we are living in a fool’s paradise where governments overspend but are unwilling to raise the money to pay the bills.
“I think intergenerational conflict is inevitable. It will become politically explosive. The baby boomers will say they paid taxes into the system and are entitled to take money out, but it’s not like an insurance policy. These are transfer programmes, they are not a prepaid annuity programme. Our politicians have lied to us. I think the problems will happen in the next 10 years. Roughly six years from now, the majority of baby boomers will have retired. Baby boomers and our parents were no longer the majority of the voting population as of 2009, and will be outnumbered 2 to 1 by 2020. Baby boomers will have less power at the ballot box. But there’s also a fairness issue. We’re expecting our grandchildren to take care of us when we have more money than them.”
I pointed out to him that in Australia, the family home is exempt from asset tests for pensions, and a couple can have a million dollars plus an expensive home and still be eligible for a part-pension. He believes such thresholds must fall in coming years, and at some point, politicians will address the family home exclusion. It will be argued on fairness grounds and neither party will defend the baby boomers.
Perceptions of the wealth management industry
Following a Research Affiliates’ conference earlier this year, I wrote this report on the criticisms of our industry from many of the speakers. Active managers are not worth the fees, we don’t know how to value companies, asset consultants don’t add value. Should we be disappointed with what our industry has achieved?
Arnott does not try to defend Wall Street. “As a business, we have asked where has our industry failed the end clients. Once in a while we ask what’s going wrong. I’m not cynical enough to think our industry is deliberately nefarious but there are a lot of paths of least resistance, people trying to make money in convenient ways. Not necessarily what’s the best way to help clients succeed. Our industry attracts a lot of people who ask what can I do that can be sold for a premium price, that hopefully make money for clients but hopefully more money for me. That’s why Jack Bogle’s insights on indexing were such a revelation.”
I asked if part of the reason we are in this position is that our industry is dealing with human emotions, individual reactions and behavioural characteristics, and it’s almost impossible to know how the market will react to events. Unlike a surgeon who cuts into a body and each one looks basically the same.
“A surgeon operates under the Hippocratic Oath of keeping clients from harm. If your customers die, you’re not going to have a career very long. In investment management, a lot of people don’t have the institutional equivalent of the Hippocratic Oath.”
As our industry seeks to improve its professional standards and build trust with the public, it’s worth looking at an extract from the Oath:
“I will apply dietetic measures for the benefit of the sick according to my ability and judgment; I will keep them from harm and injustice … I will neither give a deadly drug to anybody who asked for it, nor will I make a suggestion to this effect … Whatever houses I may visit, I will come for the benefit of the sick, remaining free of all intentional injustice … If I fulfill this oath and do not violate it, may it be granted to me to enjoy life and art, being honored with fame among all men for all time to come; if I transgress it and swear falsely, may the opposite of all this be my lot.”
There’s something fundamentally good about that.
Graham Hand was General Manager, Capital Markets at Commonwealth Bank; Deputy Treasurer at State Bank of NSW; Managing Director Treasury at NatWest Markets and General Manager, Funding & Alliances at Colonial First State. The opinions in this article provide general information only and do not take account of the personal circumstances of any investor.