The transcript from this week’s MIB: Rob Arnott of Research Affiliates is below.
You can stream/download the full conversation, including the podcast extras on iTunes, Bloomberg, Overcast, and Stitcher. Our earlier podcasts can all be found on iTunes, Stitcher, Overcast, and Bloomberg.
This is Masters in business with Barry Ritholtz on Bloomberg Radio.
BARRY RITHOLTZ, HOST, MASTERS IN BUSINESS: This week on the podcast I have a special guest. His name is Rob Arnott and he is the creator And Chairman of Research Affiliates, a fundamental indexing firm that has strategies that manage over $200 billion in assets.
Rob is perhaps best known for popularizing the concept of fundamental indexing, often called “Smart Beta” although he takes issue with that moniker, he thinks it’s just become a marketing term.
This is really a fascinating conversation. Every time I speak with Rob, I learn something
new. This time I discovered that he has co-authored a number of papers with the great Peter Bernstein which was something I didn’t previously know. If you are at all interested in things like fundamental indexing, what’s wrong with market cap weighting, how large that sector can grow, the advantages of factor-based investing, and I also learned that there are now over 500 such factors, I had no idea, I knew it was hundreds, I had no idea it was that many. This is really a master class in this space.
So with no further adieu, here is my conversation with Rob Arnott.
My extra special guest this week is Rob Arnott, he is the founder and chairman of Research Affiliates perhaps best known for popularizing the concept of “Smart Beta” better known or better described as fundamental indexing. RAFI does not consider market cap, focusing instead on four primary factors, sales, profit, book value, and dividends. Arnott formed the firm in ’02 in Newport Beach, California, investment strategies developed by Research Affiliates or RAFI as it’s better-known, manages over $200 billion in assets, Rob Arnott, welcome back to Bloomberg.
ROB ARNOTT, CHAIRMAN, RESEARCH AFFILIATES: Thank you.
RITHOLTZ: So I mentioned you started Research Affiliates and I’m used to just calling it RAFI is the nickname everybody uses up. Back in 2002, could you have imagined then that it’s barely 15 years later and your strategies are now managing over $200 billion, did you have any expectation of how wildly successful smart beta would become?
ARNOTT: Those are two different questions. Did I expect to be this successful? Yes. Nobody starts a business without a healthy dose of optimism.
RITHOLTZ: Okay perhaps sometimes, undeserved, but even still that’s a big chunk of change. Did you expect to hit those sort of numbers this quickly?
ARNOTT: I don’t know how quick that is, 16 years is a long time, but as for RAFI the fundamental index and its growth, I couldn’t of anticipated that because we hadn’t come up with the idea yet.
RITHOLTZ: When did that first rollout?
ARNOTT: We first thought about the idea of indexing in non-capitalization ways in 2003 we’ve formalized our research and completed the development of the idea by mid ’04, we were live with assets by the end of ’04, first fund was launched by PIMCO in ’05, first published index was by FTSE in November of ’05 so…
RITHOLTZ: Barely a dozen years, that’s even faster scale up.
ARNOTT: Yes, yes.
RITHOLTZ: Not a lot of funds scale up to 200 billion in a dozen years.
ARNOTT: That’s true, that’s true. But keep in mind it’s not 200 billion of assets under management, we licensed the idea through distribution partners we have the help of PIMCO, Schwab, Invesco, Nomura, FTSE and Russell…
RITHOLTZ: You couldn’t get any names that anybody recognized? (LAUGHTER)
ARNOTT: We keep looking we keep hoping somebody known actually signs onto the idea.
RITHOLTZ: So that — let’s digress and talk about that a moment. That’s a fascinating model where, now I know you guys also manage money directly.
ARNOTT: Not anymore.
RITHOLTZ: Not anymore. So that’s a change since the last time you were here. When did you stop directly managing money?
ARNOTT: We decided in 2014 that 5% of our assets under”management” were money – was money that we actually managed, 15% of our revenues came from that and the tail was wagging the dog. We were winding up with distribution partners fearful that we
were going to compete directly with them.
RITHOLTZ: That makes sense.
ARNOTT: And we decided we don’t need these complications, let’s stick to what we’re best at and so we approached PIMCO, our largest affiliate and in effect, said “Would you like this $8 billion book of business?”
RITHOLTZ: And they said they?
ARNOTT: They said “At a price tag of zero, that’s not a bad deal. I think we’ll go for it.”
RITHOLTZ: You know, if you were to come to me, I would’ve given you the same deal they gave you.
ARNOTT: Oh my goodness, that didn’t cross my mind, I wish I had thought of that. (LAUGHTER)
RITHOLTZ: So this is kind of fastening. So what I find so intriguing about your model in addition to the intellectual property but essentially you’re in the business of licensing these indices to other people to do, you know, the roll up your sleeves and do the
trading, do the client servicing, do which is complex and filled with risk and expensive, so you really have the sweetest part of the of the pie.
ARNOTT: For us, it’s the sweetest part because it’s what we love to do.
RITHOLTZ: And it’s what you I will ostensibly would imagine you do best, let the other people who are experts in trading and have you…
ARNOTT: I think not being involved in trading back office, calldesks is a wonderful thing, I think there are people who are really good at that and I want them to do what they’re really good at. In effect, being in the business of product innovation and licensing, we face an unusually high hurdle because our clients are our distribution partners and they don’t need us, they have their own R&D teams…
ARNOTT: And so for our business to succeed, they have to see us as an extension of their own R&D team complementary to what they do and not all organizations can think that way. You have to be willing to go against the not invented here syndrome.
RITHOLTZ: So that sort of puts a little more heft on the name of the firm, Research Affiliates, because essentially you provide intellectual property and research strength to the affiliates you work with. I never really thought of it in quite those terms but really that’s what RAFI does.
ARNOTT: That’s exactly right.
RITHOLTZ: Was an intentional or did we — did you just happen to stumble on that?
ARNOTT: A little bit of both. I was running first quadrant at the time and had decided if I’m ever going to start my own business, I ought to do it sooner rather than later. And so I was running both in parallel for two years, running both in parallel for two years meant I had to studiously avoid conflicts of interest.
So initially we started out saying let’s sub advise, let’s license our ideas and we found that that business model works, so we stuck with it.
RITHOLTZ: Quite fascinating.
Let’s talk a little bit about factors investing, Fama-French famously identified first the three factor model, then the five factor model, and then the seven factor model, are there still factors out there that have yet to be discovered?
ARNOTT: Two answers to that question. Firstly, yes, there will be — there have already been 500 factors published.
ARNOTT: And there will be hundreds more. Now the more pertinent question is how much of this is data mining.
ARNOTT: Finding relationships that prevailed in the past that have no reason to prevail in the future.
ARNOTT: And how much of it is truly factors that drive price that can be truly a reliable source of excess return.
RITHOLTZ: Meaning is there enough outperformance here that can be captured by a portfolio?
RITHOLTZ: So of those five — so it if these were really good factors, why wouldn’t we create a — if not a 500 factor portfolio, “Hey, let’s put these in order of the strongest outperformance generators and here are the 50 or 25 best factors.” Why can’t we do that?
ARNOTT: Well, I wrote a paper a couple of years ago called “How Can Smart Beta Go Horribly Wrong?” and…
RITHOLTZ: I remember that.
ARNOTT: It was massively controversial, I thought the controversy was amusing because if I’d written a paper entitled “How Can Stockpicking Go Horribly Wrong?” and I
offered the sage insight that if a stock soars and its fundamentals haven’t, so it’s valuation multiples have soared, its past returns will look artificially wonderful, and if there’s any mean reversion on valuations, its future performance will, to use a technical term, suck.
ARNOTT: So people would’ve read that paper and said what’s this nitwit talking about? Everybody knows that.
ARNOTT: By saying exactly the same thing about factors and smart beta strategies, I was pilloried for suggesting that the same thing could apply for strategies. Now if you go back historically, you find that the alpha of many of the smart beta factors have has not been tested in terms of how much of that excess return came from rising valuation multiples, we might as well have an Apple factor that simply says Apple has outperformed magnificently, it is a powerful factor, you have a long Apple short everything else factor, and because of the past performance, we know it’s going to continue to work.
RITHOLTZ: Let’s digress a little bit and then define factors for people who may not be familiar with Jean Fama who won the Nobel Prize a few years ago for his for a lot of his work, the original and it’s Jean Fama and Kenneth French at Dartmouth, Fama is at Chicago, the original Fama-French factor paper was small capitalization value and I’m trying to remember was it momentum or quality…
ARNOTT: No, market beta.
RITHOLTZ: Market, so that’s…
ARNOTT: That’s the three.
RITHOLTZ: Okay and then when we move to five.
ARNOTT: We added quality and momentum,, I believe.
RITHOLTZ: Right, so that’s next lot. And then seven, I don’t even know what the next two are.
ARNOTT: I’m not certain but I think it’s illiquidity and investment.
RITHOLTZ: Right, so all of this comes back to — let’s keep it simple, low-cost stocks over long periods of time, low of better value stocks, not expensive stocks, I don’t mean low price…
RITHOLTZ: Tend to outperform expensive stocks over the long haul.
ARNOTT: Exactly right. Now advocates of efficient markets will say it’s got to be because of some kind of hidden risk, because you can’t get something for nothing.
RITHOLTZ: I would push back against that and say it’s not risk with value, might be risk
with small-cap there, and then there is the liquidity issues, but with value, it’s the psychology, it’s the behavior.
RITHOLTZ: Of who wants to buy this — Domino’s is one of my favorite examples, Domino’s had a big hole run of issues late 90s early 2000 the stock did poorly people with thinking, “All right, well that chain is pretty much done.” And Domino’s over the past I think it’s either 15 or 20 years has handily outperformed Apple. I may be getting the timeframe wrong.
And so that’s the psychology of who wants to touch that.
ARNOTT: And if you look from the trough in 2009, Citi ever so briefly dipped below a buck.
RITHOLTZ: I remember that.
ARNOTT: BofA dipped to roughly 2 bucks, and since then, those have handily outperformed Apple. So but they’ve outperformed it from a starting point of being thought on deaths door.
ARNOTT: So value ,it seems to me, does have a behavioral basis. Basically when you have a value orientation you’re buying what’s unloved, what people want to shun. That should be rewarded. Now is it a hidden risk factor? Only psychologically.
RITHOLTZ: Well let me push back a little bit over there. Two companies in the financial crisis look terrible, one of them is AIG, the other’s Lehman Brothers, you can buy AIG rescued in and since pretty decent, not great, but pretty decent returns off of the bottom.
RITHOLTZ: And Lehman, I guess we could call that a value trap although there were elements of fraud and repo 105, there was a whole different set of problems with Lehman, but the risk with value is am I buying something that’s going to be a zero?
ARNOTT: That’s known as a value trap, it’s a stock that looks cheap on its way to zero.
Now it’s hard to have a whole sector that looks cheap on its way to zero, I coined the term anti-bubble in 2009 to describe what I perceived as the inverse of a bubble where an entire sector of the economy is priced as if they’re all headed for oblivion when in fact every failure clears the runway for the survivors to have higher profits, higher margins,
and greater success ahead.
So unless you wanted to accept the notion of Armageddon, the end of the economy, you — it made sense to think that collectively, this sector was being dismissed when it shouldn’t be.
RITHOLTZ: There’s a whole group of people that are the Armageddon traders I think the FTE call them the plastic bears, they will scream Armageddon, but then they’ll “Here’s what we can sell while we are waiting for Armageddon.”
RITHOLTZ: The other thing about anti-bubble is so fascinating, you could say there’s an anti-bubble in, what was it, home builders in ’05 and mortgage brokers and bankers in ’06 and pretty much anything else in finance in ’07 and each year…
ARNOTT: Almost every — there’s almost always some sort of bubble in the market somewhere in some sort of anti-bubble in the market somewhere. If you go back to early 2016, emerging markets deep value was priced at 2 to 3 times cash flow and it’s not as if the emerging economies of the world were collectively all going to go bust.
So it represented an extraordinary opportunity for RAFI, the fundamental index in emerging markets was briefly trading for Shiller P/E ratio below six.
RITHOLTZ: Wow, that’s amazing. Let’s talk about a study you did way back when looking at the S&P 500 index, which theoretically is a passive, and we’ll put a footnote on exactly what passive means, index.
You found from 1989 to 2017 the last year there was a full year of data available, stocks added to the index underperform those that were kicked out by an average of 23 percentage points over the ensuing 12 months.
ARNOTT: That’s not a bad gap in return.
RITHOLTZ: Oh my goodness, that’s amazing. So what are the implications of this and what does this mean about the stockpicking acumen of the editors on the committee of the S&P index who select the stocks that go into it?
ARNOTT: I don’t fault the index committee for the way they make choices, they are under — their clients are the people who license the index.
ARNOTT: And the people who license the index want the index to include all the names that are hot, beloved, and are embarrassing not to have in the index.
RITHOLTZ: Just added was Twitter as of this taping.
ARNOTT: Okay. And if there’s a stock that has been brutalized, unloved, dirt cheap and nobody wants it, it’s embarrassing to have it in the index, and of course they are going to take those out.
Now what happens is two things. Firstly, they announce a change and they announce the date the change will take effect, that gives the index funds a grace period in which to trade where they’re going to move those stock prices and those stocks will still be in the index so they won’t create a performance drag.
RITHOLTZ: Hey, everybody please front run our trades.
ARNOTT: Well, there’s a hedge fund community that does exactly that. So the trades are made, the positions built and then given over to the index funds on the effective date, preferably at or near the close. The stocks added when you compare them with the discretionary deletions, deletions that aren’t related to corporate
actions. Outperformed by nearly 9% during that grace period, so when an index fund say we don’t move stock prices with our trading, that’s rubbish.
RITHOLTZ: They let other people move it on their behalf and then they could say, oh look, we haven’t moved this.
ARNOTT: Well there’s that and then there’s also the simple fact that the ads beat the
discretionary deletions by 9% during a period of days. Well that’s a big move. So you also have part of that 23% return difference in the subsequent year is simply mean reversion taking the price impact of the index funds back out.
And part of it is quite simply the stocks added are extravagantly expensive on average and the stocks dropped are usually at deep discounts, over 90% of the ads are companies trading at premium multiples over 90% of the discretionary deletes are trading at a discount and the average gap between valuation multiples of the ads and of the deletes is more than three to one.
RITHOLTZ: That’s amazing. So let me make the case for “passive indexing” I think smart beta, let me caveat this, smart beta is the wrong phrase, it should be fundamental indexing, passive investing is a wrong phrase, it should be low-cost indexing, but here’s the pro-indexing argument and I want you to take this argument apart.
This is the most cost-effective, least expensive way to get exposure to equities, it has the lowest amount of turnover, the least amount of tax consequences and everybody seems to have the greatest difficulty outperforming the S&P 500 so we are going to keep using that as the benchmark going forward. Discuss.
ARNOTT: The — Bill Sharpe wrote a piece in the 1990s entitled the arithmetic of active investing, and it’s a very simple thesis. The market is capitalization weighted, the index
fund span almost all of the market and is capitalization -weighted, you take that portfolio, all of the indexers out, and what’s left is what active managers collectively own, well it’s the same portfolio give or take some wiggle room.
So if it’s the same portfolio, active managers should have the same performances index funds minus costs and the costs are higher for active managers. That arithmetic is not just true, it’s a truism, that means that if you’re choosing active managers with absolutely no skill, you should expect to earn index returns minus.
When you choose an active manager, this doesn’t mean in choosing active managers is a waste of time, what it does mean is you’d better have a good answer to the question if this active manager is a winner, because there’s a loser on the other side of their trades, who’s the loser and why are they a willing loser?
For fundamental index, the answer to that is really simple. This is a strategy that contra trades against the market’s biggest and most extravagant bets and so the loser on the other side of the trade is the performance-chasing lemmings who are legion.
RITHOLTZ: Here’s the Bill Miller push back, most active managers are as you’ve described with a very low active share and essentially they are closet indexers so why on earth should anybody pay a high fee when you can pay a low fee and get 95% of the same portfolio? Fair criticism.
ARNOTT: It’s a fair criticism, there’s a lot of active managers hiding in the bushes near
the benchmark, most active managers are constantly looking over their shoulder at the benchmark and worrying about beating at the beauty of fundamental index and
of smart beta as it was originally defined smart beta originally meant strategies that break the link with price that don’t pay any attention to market capitalization or price in setting the weight of a stock. This term is been stretched to the point of meaninglessness.
ARNOTT: But under that definition, you do have the advantage that you are going to be contra trading against the market’s biggest bets whether you are equal weighting or fundamental index or minimum variance, you’re going to be having an anchor, a target weight that isn’t related to price. So whether the price soars and tumbles, you’re going to be selling and buying, it’s a built-in structural sell high buy low discipline.
We were talking earlier about traditional passive investing war or low-cost indexing, let’s do a little bit of a compare and contrast with fundamental indexing and we touched on this, I want to give you a quote from Burton Malkiel, smart beta strategies are riskier than index funds and not right for individual investors. What is Professor Malkiel getting
ARNOTT: Malkiel comes from the efficient markets community, he believes, he wrote “Random Walk Down Wall Street” back and I think the 60s. It’s interesting to note that if you believe that the more the share prices equal a fair value that we cannot see, plus or minus an error adding up to the price, and if you believe the market is constantly hunting for those errors in trying to fix them so that the error is mean reverting, then contra trading against big price moves has a structural alpha that is in fact the key driver of the value affect, if you look at value strategies, the alpha comes from the rebalancing, not from the cheapness of the stocks.
RITHOLTZ: Well, isn’t that the same thing when we say a stock is cheap, we’re essentially saying it’s trading at a discount to its fair value and once that rebalance occurs, it should snap back to that and there are gains.
ARNOTT: Well just as an example, fundamental index overweight stocks that are trading at discounts proportional to the magnitude of the discount, underweight stocks trading at premiums proportional to the magnitude of the premium.
So you’re systematically down weighting the growth stocks and up weighting the value stocks, you’re saying thanks for the gains on the growth stocks, let me trim it back to its economic footprint, thank you for the discounts on the value stocks, reweighting it back up. So there’s a structural value tilt. Well why then does the strategy relentlessly beat cap weighted value indexes, Russell value, IFA value, IFA emerging markets value,
winning against the value indexes 70% or 80% of the time year-by-year.
It does so for the simple reason that value indexes are themselves cap weighted, so they are going to overweight the overvalued and underweight the undervalued value stocks.
RITHOLTZ: Even within the universe of value.
Think of it this way. If a stock outperforms in the future, ten it must’ve been under underpriced today, if it underperforms in the future of must have been overpriced
today. And what stocks get the most weight in a cap weighted portfolio? Those that are overpriced?
RITHOLTZ: So let’s address that because that raises a really interesting question, when we look at cap weighted indexes, we end up owning more of the names that are outperforming…
ARNOTT: Have been outperforming.
RITHOLTZ: Have been outperforming.
ARNOTT: Have been outperforming.
RITHOLTZ: And since we know momentum is a factor, the assumption is that those outperformers will at least for some finite period in the future continue to outperform so we end up owning more of the winners are keeping winning and less of the losers are keeping losing or so goes the cap weighted index argument.
What’s wrong with that claim? Don’t we want more exposure to stocks that are winning?
ARNOTT: Here’s what’s fascinating. Yes, momentum is a powerful factor across multiple asset classes spanning decades but within stocks, momentum was first published by Professors Jagadeesh and Titman back in 1992 or 1993, and since 1999, momentum as a strategy in the stock market hasn’t worked. That is to say…
RITHOLTZ: Or hasn’t worked, its underperformed some other factors.
ARNOTT: No. High-performing stocks have underperformed low performing stocks on average since 99.
RITHOLTZ: Is that due to the dot com crash in the great financial crisis, how is it operated? Now I know you can’t say I only want to invest when we’re not in a bubble or in a crisis but how significant were those events to the underperformance of
ARNOTT: Tremendously significant. You put your finger on it that when you have a strategy that outperforms for a while then crashes, outperforms for a while and crashes, net net it can look terrible if you can use it only when it’s going to work, great.
RITHOLTZ: Let me know when you set up an index that does that.
ARNOTT: Exactly. And point of fact, when momentum is telling you the extravagantly priced growth stocks are the ones with momentum, that’s when it’s more likely to have a
crash than at other times when momentum is saying the value stocks have turned and are showing positive momentum, that’s when momentum historically works best. So the combination of the two value and momentum tends to be a really nice combination.
But be very careful about using momentum when it’s telling you to chase bubble stocks. If you can switch it off, do.
RITHOLTZ: So let’s talk about the combination of value and momentum. Wes Gray of Alpha Architect wrote a piece was title I love about combining value and momentum, which essentially says even God would get fired as an active manager and he said — he suggests that while we know the combination of value and momentum outperforms just
about any other combination we come up with, there are these occasional drawdowns that can be brutal.
RITHOLTZ: So how do we explain why value and momentum outperforms just about any other combination of factors if we still get these really horrific periods of time where “Gee, this doesn’t seem to be working.”
ARNOTT: Yes, well, the simple fact is no strategy is going to work all the time, contrarian investing is arguably the most powerful and reliable long-term form of investing.
Basically whatever is newly cheap is going to have performed terribly, it will have inflicted pain and losses, people don’t want more of that.
Imagine an investor saying “Oh, I just lost a ton of money on this, give me more of that” that’s what a contrarian investor does, a strategy that’s provided great joy in profit, a stock that’s provided great joy and profit. How many people look at that and say “Oh, get me out of here.” that’s what a contrarian investor does.
And so with contrarian investing, you’re going against the crowd, that’s profoundly uncomfortable, and whenever it fails, whenever it doesn’t add value because the expense of popular stocks are getting more expensive and the cheap garbage stocks
are getting more cheap, anytime it does fail, people start to think you’re an absolute idiot.
RITHOLTZ: So let’s talk about that for a second because my office has a value tilt as does all everything that the research affiliate or many, I shouldn’t say everything but many…
ARNOTT: Pretty much everything.
RITHOLTZ: Just about. And yet we’re in a period where we have the FANG stocks, we have these tech companies doing great, and value is going through one of its periodic stretches of underperformance where people stop and say “I understand the concept behind value but look at Netflix…
ARNOTT: Exact point.
RITHOLTZ: Why do we want to own these cheap stocks, the expensive stocks are doing great? So two-part question. A, why do we go to these periodic spasms of significant underperformance and B, is that what enables value to over the long haul, outperform growth.
ARNOTT: Let me answer B first, yes that’s exactly why it outperforms in the long run because it’s uncomfortable, but the periods and because when a ghost or a period of disappointment is very easy for people to abandon a strategy that is uncomfortable…
RITHOLTZ: Making the cheap stocks that have become cheaper even cheaper still.
ARNOTT: Correct. So it is really important when we wrote the paper “How Can Smart beta Go horribly Wrong?” we showed that when a strategy becomes more expensive, it creates a surge in relative performance making the strategy look unusually powerful, well sowing seeds for future disappointment because the strategy is nearly
expensive. The same thing applies to value. Value in 2000 was profoundly cheap. The gap between growth stocks and value stocks was eight to one in valuation labs.
By 2007, it was 2 1/2 to one. Two and a half to one sounds like a big gap it’s not, it’s considerably narrower than usual. And so in 2007, objectively, value was priced high relative to its own history and that’s what sets the stage for the quant crash in August of 2007.
RITHOLTZ: That was a very crowded trade a lot of people had — but that, you know, you referenced quants, that makes me think of a quote of yours which I don’t believe is still true or maybe you could disabuse me of that notion. You once wrote our industry hates arithmetic. Now that was certainly true decades ago given the amount of things, the amount of assets managed by quantitative strategies and just the flood of smart quant analysts coming into the industry. Does finance still hate arithmetic?
ARNOTT: Oh my goodness, yes, it doesn’t hate mathematics, the notion of quantitative methods probably almost more popular than ever before, only 2007 might even come close. But the notion of simple arithmetic, the arithmetic of returns is you earn a yield, you have a growth and income and you have changes in valuation multiples. If you know those three numbers, you know your rate of return.
Disaggregating historical returns into those three components gives you a very clear picture of where returns came from and looking ahead, you know what the yield is, you know that historical growth is probably not a bad predictor for future growth which
leaves you valuation change. If valuations are high, you’re more likely to have mean reversion down, if valuations are low, you’re more likely to have mean reversion up.
So when markets are expensive you have a lousy yield, growth is what it is and valuations are more likely to come down and rise.
And when markets are cheap, the opposite holds true. So that’s the arithmetic people hate. When — we’re in the 10th year of a bull market, 10th year of an economic expansion, when times are good and people have had wonderful success, their expectations for future returns go up not down. Now that’s interesting because when markets are rising and yields are falling, your forward-looking return is eroding.
RITHOLTZ: Right, your expected return should be lower when things are pricey and higher when they are cheap.
ARNOTT: Right and people think the opposite way. It’s interesting that the market lows in 87 and 2002 and again in 2009, each of those three episodes I found myself on a plane next to somebody who was saying I’m never going to be investing in the stock market again.
RITHOLTZ: All three times.
ARNOTT: All three times.
RITHOLTZ: That fascinating. Can you stick around? I have a ton more questions for you.
ARNOTT: Sure thing.
RITHOLTZ: We have speaking with Rob Arnott. He is the founder and chairman of Research Affiliates. If you enjoyed this conversation be sure and check out our podcast extras we keep the tape rolling and continue discussing all things Smart Beta.
You can find that where ever finer podcasts are sold. We love your comments feedback and suggestions. Write to us at MIBPodcast@Bloomberg.net check out my daily column on Bloomberg.com, follow me on Twitter @ritholtz, I’m Barry Ritholtz, you’re
listening to Masters in Business on Bloomberg Radio.
Welcome to the podcast. Rob, thank you so much for doing this you — we were discussing earlier, you were one of the original people we kind of first tested the water with a podcast with…
ARNOTT: This is a great series.
RITHOLTZ: Back in 2014, I want to say…
ARNOTT: Sounds about right.
RITHOLTZ: That’s when we launched it and you’re one of the people where a couple years later, I kind of said, I wanted to ask him about this, I didn’t even bring up that, I forgot this I forgot that, I got to bring him back and go over some of these things.
So thank you so much for returning I’m fond of saying this is the most fun I have all week so this is a…
ARNOTT: Poor you.
RITHOLTZ: Yeah right. I had to sit down with people like you Danny Conoman and
Ray Dalio and Howard Marks, that is my cross to bear…
ARNOTT: Yes, yes, it’s tough duty.
RITHOLTZ: Yes, so it’s an ugly, dirty job, but somebody go to do it. Let’s — there is ton of stuff I didn’t get to and since we were talking about expensive stocks and tech stocks, let’s talk a little bit about FANG. We see the FANG stocks that have you know just taken off over the past five or so years but there’s also cutlets to compare and contrast with the 1990s these are real businesses with the actual revenue…
ARNOTT: Some of them are…
RITHOLTZ: And profits, well Apple Amazon and Netflix, Google go down the top 10 tech stocks it’s not like the ephemeral or — or is it let me ask you the question as opposed to answering, what are the parallels between today and the sort of mania we saw in the 1990s, are there parallels?
ARNOTT: There sure are. I wrote a paper recently entitled “Yes, It’s A Bubble, So What?”
RITHOLTZ: Okay, that’s one of my questions, let’s go over that because I love the title.
ARNOTT: Yeah the point of the paper is twofold. One point that we make is that the term is bandied about without a definition.
RITHOLTZ: A bubble.
ARNOTT: Bubble. And so we make an effort to give an objective definition that people can actually use as a test for saying is this a bubble? And that objective definition is one where simple measures of fundamental business success you have to make exceptionally aggressive assumptions to justify the price of a stock or a sector or a country.
RITHOLTZ: So you don’t like the Potter Stewart definition, I know it when I see it…
ARNOTT: It’s a little vague.
RITHOLTZ: Right, referring back to the point…
ARNOTT: Yes, it’s a little vague.
And the second part of the definition is that the marginal buyer is somebody who is not buying because of a careful analysis of fair value, but is buying because they expect to be able to resell to somebody else at a higher price.
RITHOLTZ: The greater fool theory.
ARNOTT: Correct, so you look at the FANGs today, the marginal buyer in most cases is not somebody who’s done careful analysis of forward-looking expect rates of return, the other parallel with the tech bubble is that the at the peak of the tech bubble, five of the eight largest market cap companies on the planet were tech companies. Today seven of the eight largest are tech companies, the valuations aren’t as extravagant as they were in 2000, but the concentration at the top of the list and global market cap is even more.
RITHOLTZ: So let me push back on that because we’ve been debating this with some folks in the office. So technology today represents the culmination of human ingenuity and effort and why wouldn’t technology companies that don’t require a giant infrastructure think back to the railroads?
It costs inflation-adjusted billions to lay thousands of miles of tracks and all the manpower you had to hire and locomotives in and railcars and all that stuff you know…
ARNOTT: Capital intensive.
RITHOLTZ: Right, completely capital intensive, completely labor-intensive.
Now a startup is a couple of guys and a laptop and an Internet connection so you don’t have the same capital requirements you don’t have the same labor intensity and the ability to scale is immense so shouldn’t A, shouldn’t these companies be trading at a
premium and B, shouldn’t they be dominating the market because hey, this is the future and technology is driving us all with robots and driverless cars and automation you name it.
ARNOTT: Yes, but you tell me which companies are going to be the center of innovation 10 years from now and I will happily acknowledge that those companies deserve massive valuations today, huge multiples.
The problem with that thesis is really simple and that’s casting a broad net, you’re going to have a lot of companies with a fantastic story. Back in 2000, the story was these
companies are changing, it’s a new paradigm, these companies are changing the way we do business, the way we communicate, they are radically reshaping the macro economy and this industry is going to be changing our world, so of course they deserve massive premium multiples. What was overlooked was that these companies were disruptors and the disruptors themselves get disrupted.
ARNOTT: Often very fast.
So how many search engines preceded Google?
ARNOTT: How many handheld devices preceded the iPhone and were seen as utterly dominant?
RITHOLTZ: Right, Blackberry owned that market…
ARNOTT: Yes, Palm. Palm briefly was trading for market cap greater than General Motors and then both of them eventually went to zero. So you have an industry with massive change.
Here’s a fascinating thing, the 10 largest market cap companies in technology in the US in the year 2000, how many of those outperformed in the 18 years before the start of 2000 and the start of this year? Zero.
Not a single one. Not one beat the market.
RITHOLTZ: The fascinating part about tell me the company’s 10 years hence, look back 10 years ago there was no go down the list, Facebook wasn’t public, Twitter wasn’t public, Netflix wasn’t public, actually Netflix was public but they were sending DVDs through the mail.
RITHOLTZ: Go down the whole list and go to 10 years previous to that, Google wasn’t public, you could — Apple was thought to be going bankrupt.
RITHOLTZ: Amazon was a glimmer in Jeff Bezos’ eye, so it’s 10 years doesn’t seem like a long time but making the forecast 10 years hence all but impossible you could get lucky but…
ARNOTT: Here’s another fascinating thing about bubbles and about markets in general. If you take the 10 largest market cap companies on the planet on average, only two of them are still on that list 10 years later.
RITHOLTZ: That’s amazing.
ARNOTT: It’s eight are underperformers, now the eight that fall off the list are obviously and assuredly performing worse than the eight that replaced them and the eight that are…
RITHOLTZ: By definition.
ARNOTT: And the eight that are on the list today have a bigger weight than the ones that replaced them. So you have this drag associated with capitalization weighting so even the top 10 reinforces the notion of what’s wrong with indexing. That doesn’t make it easier for active managers to add value if they’re looking over the shoulder and wondering how am I hurting myself by not owning Netflix or shouldn’t I really take advantage of the dip and buy more Tesla?
RITHOLTZ: Now I just — were recording this on a day when the Wall Street Journal had a column out I’m sorry, it was Bloomberg, had a column out that said “Apple, a stone’s throw away from $1 trillion” and the biggest market cap company is actually trading in a much lower multiple than the previous times when at least on the inflation-adjusted basis we had companies approaching the same level. Apple at 18 times is much cheaper than go down the list, when it was QUALCOMM, when it was Microsoft, when it was whoever, so are the FANG, the problem I guess we run into Apple a new favorite of Warren Buffett’s is cheap, Amazon now that they’re starting to show a profit by any rational measure other than pure growth and market share looks very expensive.
ARNOTT: As does we work on a bunch of others.
RITHOLTZ: Well the private companies, Uber works, Theranos, that one didn’t work out too well but no go down the list of the so-called unicorns, what does that tell us about how much capital is chasing…
ARNOTT: Exactly right and when you’re talking about the unicorns the very simple fact
is some of them are worth every penny of what their valuation is today…
RITHOLTZ: Can you tell us which ones…
ARNOTT: I just don’t know which ones.
And if you can pick those Google since its IPO has been a persistent favorite for value managers to underweight it.
ARNOTT: And for value manager — for deep value managers to even short. Okay, well that’s not working out so well.
ARNOTT: But for every Google, there is a Palm, there’s an array of companies where you look back and say as you did with Theranos, that didn’t work out so well. When Theranos was hot, it was going to change the world.
RITHOLTZ: Right but that was an outright fraud that’s very different and Elizabeth
Holmes the founder and CEO just settled fraud accusations with the SEC, the companies laid off almost all of its staff, I heartily recommend Carreyrou’s book “Bad Blood” it’s a fascinating read and we will get the books in a minute, but where there aren’t cases of outright, where it is in a scam, where it’s which a legitimate company who for whatever reason it’s moment may have passed, how can you determine with any degree of confidence this is a company that is going to be around for 10 or 20 years?
ARNOTT: You can’t. You can’t say which of the popular beloved star companies are going to be around in 10 years let alone which ones are going to outperform. If history is at an example, there were tech companies that were described as being sensibly priced in 2000 because they were only 20 times the two-year forward earning.
RITHOLTZ: Well look at Microsoft which has since under the new CEO Satya Nadella has since returned to — very quietly has become the third largest or third most profitable company in the world, third largest market cap and I don’t know if that is tech stocks or stocks in general, and that’s something that kind of was left for dead after the dot-coms.
RITHOLTZ: So no one would’ve — very few people were predicting Microsoft was going to make a comeback, I’m surprised Buffett with his friendship with Gates didn’t recognize the value in Microsoft but the question that all this comes to is if history tells us that these top 10 stocks most of them to drop out of the top 10 is it simple
valuation mean reversion or is there something else at work here?
ARNOTT: Part of it is valuation mean reversion, part of it we wrote a piece called “Too Big to Succeed” kind of a play on the notion of too big to fail and the point of that paper was largest market cap companies get there because they’re big successful businesses and trading at high multiples. You don’t get to the top of the sector or top of the market without both conditions generally being true.
For that reason, these companies are likely to disappoint just on a valuation
basis. Now, add on top of that the fact that now these companies are so visible that
everyone’s taking shots at them. Their competitors are after them, regulators want to put a new notch on their gun barrel, the list goes on and on.
And so Apple goes from being a beloved trendy darling to being under attack from regulators all over the world questioned and challenged because of the bugginess of some of their software these days.
RITHOLTZ: Look at General Electric as a perfect example, is there a greater loved darling than GE in the 90s?
ARNOTT: Not at all and I best of my recollection it has not outperformed since then by much.
RITHOLTZ: No, it is gotten — so I have to ask you keep referencing various white papers, “How Smart Beta Can Go Disastrously Wrong” “Too Big To Succeed” there was one other you mentioned.
When you and the research staff at Research Affiliates are thinking about running a white paper of putting it together, who is your target audience for that? Are you writing that you know Daniel Bornstein very famously said I write to figure out what I think, I’m going to suggest that’s not the motivation with your white papers, you guys already know what you think, who is the target audience for those papers?
ARNOTT: You know it’s a really good question because there’s not a really good answer. Yes, we’d love for our papers to be accessible to the ordinary Joe on the street/
RITHOLTZ: Not many top investors aren’t really reading white papers.
ARNOTT: They aren’t reading them and the papers are in many cases, too subtle, too mathematical, too complicated.
RITHOLTZ: When I get page 7 and it’s all formulas, that’s where I tap out.
ARNOTT: No, we don’t do that.
We don’t do formulas the way finance journal would but we do I think our general target would be somebody with the sophistication of the average financial advisor, if we’re writing over the heads of the average financial advisor, we’re not doing anybody any good.
ARNOTT: If we’re writing below that level, we run the risk of oversimplifying and we do love a challenging conventional wisdom. I’ve made a career out of looking at things that are generally perceived to be true and testing them, and sometimes they are true and
sometimes are not and when they’re not, you get a paper out of it that the rattle some cages and that may be even can change the business in a modest way.
So one of the things that I’ve found is that when you write a paper that challenges conventional wisdom, there’s somebody out there, in fact usually there’s lots of people out there who’ve made a career on that conventional wisdom and boy are they angry.
RITHOLTZ: To say the least.
So one of the questions that keeps coming up on the just low-cost indexing side is a given the growth of Vanguard and Blackrock, 4 trillion and 5 trillion respectively, I think they are going to be five and six in a short period of time, the question that always
comes up with low-cost passive indexes is hey how big can these get before it no longer works.
I look at Smart Beta from 2012 to 2017, it tripled to over 600 billion, it’s a stone’s throw now from the trillion.
ARNOTT: That is almost as big as Apple.
RITHOLTZ: Almost as big as Apple.
ARNOTT: Almost as big as one stock.
RITHOLTZ: At what point — so there is, well the biggest stock, but at what point does this top out, when does it become so large that everybody’s doing it and therefore there is no outperformance in it?
ARNOTT: Firstly smart beta has been the become a catchall phrase that spans a lot of strategies many of which aren’t smart at all, so the notion that it’s just a label.
RITHOLTZ: Right so let’s stick — forget smart beta, I don’t like passive indexing and I don’t like smart beta, let’s stick with fundamental indexing and will stick with price to sales, price to earnings, price-to-book value, price to dividend, which I think is the fundamentals where Research Affiliates began and that’s did we say that’s 90% or more of the indices you create?
ARNOTT: It’s about 80% of our AUM.
ARNOTT: The rest is global asset allocation strategies.
Now in terms of capacity, different so-called smart beta strategies have different capacity, some of them are very high turnover, heavily involved in illiquid companies for instance, Roger Ibbetson’s favorite strategy is an illiquidity strategy, you’re going to
focus on companies with low liquidity. If you’re trying to run 100 billion using that forget it…
RITHOLTZ: It doesn’t work.
ARNOTT: Not even a chance.
RITHOLTZ: But that works for small niche funds and that’s…
ARNOTT: Absolutely now fundamental index still to this day pretty much unique among the so-called smart beta strategies does have vast capacity. Why? You are spanning the broad macroeconomy, you are owning pretty much everything…
ARNOTT: Your trading consists of contra trading against the markets most extreme bets, so when a price is soaring, you are trimming. Well it’s easy to find a counterparty to those trades.
If a stock is tumbling, you’re buying, it’s easy to find a counterparty to those trades…
ARNOTT: Your trading is spread across 1000 companies instead of concentrated as with S&P 500 indexation in whatever stocks are being added or deleted that particular week.
RITHOLTZ: so Lenny channel Jack Bogle and say all that makes perfect sense but all that trading is expensive and the gains are offset by your turnover and your trading costs.
ARNOTT: We’re selling what people want to buy, we’re buying what people want to sell so our trading costs at this stage have been immeasurably small at some stage at some size, we start to move prices. We are not there yet, 180 billion, we’re not there yet.
RITHOLTZ: You know there’s a ways to go before you have to really be concerned
ARNOTT: The trading costs for classic cap weighted indexing are much more vivid much more substantial measurably so because during that grace period, you get a 9% spread between additions and discretionary deletion.
RITHOLTZ: But that’s not the trading costs, that’s the actual NAV gain or loss from the trade, they — what do they do, they lose half a dozen stocks, they do that once a year their trading costs…
ARNOTT: S&P does it multiple times a year, one or two or three stocks.
RITHOLTZ: When there’s mergers, when there’s takeouts when there’s things like that but when I look at something like a price to earnings ratio or when you’re buying things fundamentally ranked by earnings, that changes quarterly how often do you have to rebalance that index?
ARNOTT: There’s two flavors of fundamental index the original FTSE RAFI rebalance is once a year and has 10% to 15% annual turnover, that’s all. And that 10% to 15% is spread across 1000 companies, it’s not concentrated in a dozen additions or
deletions. The other flavors of fundamental index, our own RAFI series and the Russell fundamental index are — use what we call quarterly staggered rebalancing which means
every quarter you move one fourth of the way to the target…
RITHOLTZ: Which makes sense. You are spreading it out.
ARNOTT: You let momentum run on three fourths of the portfolio and one fourth of the portfolio say okay enough momentum, we are going to rebalance.
And by doing it that, we have the same turnover as once a year rebalancing still 10 to 15% annual turnover, it’s very low, it is very easy to trade, so I don’t fret about implementation costs trading costs moving market prices until we’re in the trillion dollar range.
RITHOLTZ: So we’ve talked about Vanguard as a competitor and Blackrock, let’s — let me bring up something just because I’m looking like…
ARNOTT: Well, Blackrock is one of our licensees, they run over 10…
RITHOLTZ: So they are am affiliate not really a true competitor.
ARNOTT: Yeah they have competing product and they have licensed products, they are running over 10 billion globally and RAFI strategy.
RITHOLTZ: So you’re happy with them. I’m looking at price to sales, price-to-book let’s talk about dimensional funds which is about 600 billion and their core fundamental index
is similar to yours and that they look at price-to-book and other Fama-based, Fama- French-based factors.
But really that’s the core of what they do. How do you look at them relative to Research Affiliates and what you guys do?
ARNOTT: Yes, well RAFI in US international emerging markets is as pretty reliably trounced the DFA value products and for an extremely simple reason, DFA hews to the religion of efficient markets and says were going to anchor on cap weighting for…
RITHOLTZ: I mean, within their price-to-book, it’ll be cap weighted.
ARNOTT: They’re going to cap…
RITHOLTZ: You know I’m going to get pushback and they are going to say here is where is Rob is wrong, I’m going to forward you that email and you can reply to it.
ARNOTT: I look forward to the email. But in any event, the anchor on cap weighting which is a mistake and they do wonderful work I’m I don’t want to be seen as a suggesting that they are doing something bad, they’re doing something better than conventional cap weighted indexing but they anchor on cap weighting, that’s their starting point so and that’s their mistake.
RITHOLTZ: I’m going to have to follow up with that. So I only have you for another 10 or 15 minutes I have dozens more questions, we will have to have you back for another time but let me jump into my favorite questions that we ask everybody and I’m looking forward to hearing your answers.
Tell us the most important thing that people don’t know about you.
ARNOTT: A lot of people see me as a very serious research guy and point of fact, life is short, having fun is absolutely crucial.
RITHOLTZ: And I know that about you from Camp Kotok and other places.
ARNOTT: Yes, so I don’t do anything, I don’t do any research, I really don’t do anything that isn’t fun.
RITHOLTZ: I like that answer. I’m going to skip ahead to my question number eight, what you do for fun outside of work?
ARNOTT: Well I collect vintage motorcycles fastest of their era, I like good wine and I’m a movie junkie, I have watched — write down the movies that I watch and I rate them on a five-star scale and I’ve watched over 1,500 movies in the last six years.
RITHOLTZ: Wow that’s a lot of movies do you modern stuff classic movies — was your
ARNOTT: I don’t have a favorite I don’t watch a lot of the really old movies…
RITHOLTZ: Old as in 20s and 30s?
ARNOTT: Old as in 20s 30s 40s 50s…
RITHOLTZ: I just saw Roman Holiday the other day.
ARNOTT: That is a wonderful film.
RITHOLTZ: She is just delightful, Audrey Hepburn.
ARNOTT: Yes, she was taken from us much too young.
ARNOTT: But in any event, I like variety in films…
RITHOLTZ: Wait, that is that’s Grace Kelly who was taken too young I think Audrey Hepburn lived a fairly long…
ARNOTT: Katherine Hepburn lived a long time, Audrey Hepburn I think died in her late 60s.
RITHOLTZ: You could be right I am just…
ARNOTT: Let’s Google that.
RITHOLTZ: Actually this comes up as Bing which I don’t know why, 63, you are correct, very good memory.
ARNOTT: Yes, she had a cerebral hemorrhage while walking down the street in Manhattan, just suddenly dropped, really sad. But in any event the very eclectic taste in films if it’s mainstream Hollywood predictable, I’m bored, if it is weird and strange I love it.
RITHOLTZ: Have you — I was a giant fan of the original Blade Runner did you see the sequel?
ARNOTT: So the sequel and then I went back to watch the original for a second time right after.
RITHOLTZ: The original is still an astounding piece of work.
ARNOTT: It is, it is. Both are good.
RITHOLTZ: I saw the new one in the theater and I walked out a tad disappointed but that was almost inevitable and I’m waiting a full year to see it again with a little more open-minded.
ARNOTT: Sequels are always done on the basis of an original film that was brilliant, that was extraordinary and so it suffers by comparison.
RITHOLTZ: Caddyshack 2, or…
ARNOTT: I did not see that.
RITHOLTZ: Neither did I, but the assumption is.
RITHOLTZ: So let’s talk about mentors. Who do you look at — who mentored you earlier in your career and who influenced your approach to investing?
ARNOTT: Early mentors were mostly people I worked for who were brilliant. Dick Kroll at the Boston company, Bob Lovell at Crum and Forster at First Quadrant, he founded
first quadrant and brought me in as a president and then a CEO later and those would be two of my most influential mentors, people it didn’t work for who were mentors, Peter Bernstein was massively influential in the way I think.
He was he was such a mensch…
RITHOLTZ: Against the…
ARNOTT: “Against the Gods” what a book. Here’s the here’s the pitch story, I want you to publish my book, it’s going to be a book on the history of probability theory in finance and it’s going to be a bestseller. What? And it was a bestseller, it’s sold half a million copies.
RITHOLTZ: It’s such an amazing book I’m slowly working my way through the rest of his — the rest of his work. and he influenced you from afar, did you ever talk with him or meet with him?
ARNOTT: We became very good friends. Very good friends. We worked on two journal articles together, one for Harvard Business Review and one for Financial Analysts Journal which were two of my favorite papers that I’ve been involved in, partly because he’s such an effortless writer.
The paper for the Harvard Business Review, he said what you do the first draft I did and he called me after he received it and he said, Rob there’s some gems in here but this is
a turgid mess.
RITHOLTZ: Blunt a little?
ARNOTT: A little blunt but a nice way in a…
RITHOLTZ: Hey, let me polish this up a little bit.
ARNOTT: yes, let me do a complete massive rewrite and turn it into something that the…
RITHOLTZ: That’s funny.
ARNOTT: The average businessman without any investment savvy can understand.
RITHOLTZ: Cool, and how did the paper come out?
ARNOTT: It came out in the Harvard Business Review.
RITHOLTZ: I mean what was what was your final read of it, did you like what he did to it and how could you not?
ARNOTT: How could I not. The paper was titled by Harvard Business Review, we didn’t come up with the title, “The Right Way to Manage your Pension” that’s a little arrogant but…
RITHOLTZ: It’s attention grabbing.
ARNOTT: It’s attention grabbing and it was it was an influential paper.
RITHOLTZ: So since we’re talking about Peter Bernstein, let’s talk about your favorite books what are some of the favorite things that you have read and I’m just going to assume Ayn Rand and move beyond that, what did you like?
ARNOTT: You did touch on politics which is another of my passions for those who don’t know me, I’m a libertarian, I believe in limited government which too few people do…
RITHOLTZ: Well, there are people who claim to be libertarians but really they are libertarians for a specific issue and then they want a government intervening elsewhere.
ARNOTT: Wherever it’s convenient for them.
RITHOLTZ: Right, exactly.
ARNOTT: That’s human nature. The in investments, “Against the Gods” would be
tough to beat it’s fantastic, anything by Ben Graham is a must-read…
RITHOLTZ: “Intelligent Investor.”
ARNOTT: Yes, “Security Analysis.”
RITHOLTZ: “Security Analysis.”
ARNOTT: If you want to dive in deeper.
ARNOTT: These are some of the giants of our industry. Outside of investing and actually most of my reading when I’m not working is outside of investing, a couple of really fun books are “1493.”
RITHOLTZ: Really? The year after Columbus sailed for the new world.
ARNOTT: There was a book called “1491” that examined the Americas before Columbus landed and the population of the Americas back then was probably in the t couple of hundred million range.
RITHOLTZ: Really, I would not have guessed that.
ARNOTT: Massively wiped out by measles and other diseases…
RITHOLTZ: Small pox.
ARNOTT: Where they had no built up no genetic ability to fight those diseases so 95% wiped out.
RITHOLTZ: 100 million plus people Native Americans were here before Columbus landed.
ARNOTT: Early arrivers said that the shores were teeming with
people. Fascinating. 1493 was the sequel to that book and I think it was even better it shows how global commerce has reshaped the world and how it creates seeds of tremendous risk. Another book that I’ve been enjoying immensely in part because it’s so you can pick up pick it up read a page or two and then put it down and come back to the month later and you haven’t missed a beat, it’s letters of note which is filled with letters written from person A to person B going back 3000 years to modern times, letters that are just fascinating.
A letter from a woman in China to her husband headed off to war written 1400 BC and the passion in her worrying about him wanting him to be spectacular in battle but please come home and you know it just reminds you that all of these people were human
Even a letter from Jack the Ripper to the police taunting them and you feel the evil humanity in the letter, it is just fascinating.
RITHOLTZ: I’m going to definitely check that out, that is quite impressive. Tell us about a time you failed and what you learned from the experience?
ARNOTT: Well I was invited to be a global equity strategist at Salomon Brothers in 1987, I lasted there for 14 months, it was a wonderful learning experience. I naively, I
was only 32 at the time and I naively thought I was coming in to be global equity strategist.
But in fact I was coming into reinforce sales.
Of course, of course that’s the job and I remember I was brought into ATT’s pension fund, the week after the market crashed, they were using the mean variance optimizer Markowitz optimizer, to look at their asset allocation and they were puzzled, they said we did an optimization, we pushed up return expectations for stocks…
ARNOTT: Push down return expectations for bonds because the yields
tumbled. Pushed up the risk assumption for everything by 20% seemed like a very reasonable and even conservative approach and our optimizer is telling us to get out of stocks and put it all in bonds.
RITHOLTZ: Hey, there is something wrong with that optimizer.
ARNOTT: So I came in and I explained the mathematics of why the optimizer would do that…
RITHOLTZ: Backwards looking as it is.
ARNOTT: No, it was forward-looking, it was forward-looking…
RITHOLTZ: But (inaudible) inputs coming from what just happened? Am I misremembering this?
ARNOTT: No, their inputs were forward-looking so they pushed up the return for stocks because they crashed, pulled down the return for bonds because the yields had crashed.
RITHOLTZ: And it still wanted them to put…
ARNOTT: It still wanted to put more into bonds because they push the risk up for
everything. Now I went through with them the mathematics of why it was saying that and then I concluded by saying throw out the optimizer, but stocks, well oh my goodness the reaction at Solomon in response to that was fascinating because they were salivating over the possibility of a $10 billion bond portfolio construction exercise that would make them 30 to 40 basis points on an 10 billion, an instant $50 million and here comes the strategist telling the client to do the opposite.
RITHOLTZ: Right, that is a learning lesson, isn’t it.
ARNOTT: They were livid and the lesson the lesson learned was you got to know who your client is, you got to know what they want and you got to know whether what they want is what you’re comfortable delivering.
RITHOLTZ: And our final question, tell us something you know about investing today that you wish you knew 30 plus years ago.
ARNOTT: Even 5 years ago when we launched Fundamental Index, we published a paper and immediately set about saying if you can build an enhanced index relative to cap weight, you can build an enhanced index relative to fundamental index, who better to do that than us? Well why don’t we figure out which of the fundamental measures works best and have the mix of fundamental metrics be dynamic?
And what I didn’t realize at the time, we failed miserably everything we tried didn’t work, what I didn’t realize at the time was when a strategy becomes massively more expensive it’ll have wonderful past returns and terrible future returns, so we were zeroing in on the fundamental metrics that the market was loving more and was poised to disappoint, so the enhancements failed.
Today I have a better understanding that valuation matters for factors and strategies just as much as it does for stocks.
RITHOLTZ: Quite fascinating. We have been speaking with Rob Arnott of Research Affiliates. If you enjoyed this conversation be sure to look up an inch or down an inch on Apple iTunes, Bloomberg.com, Stitcher, Overcast, wherever finer podcasts are sold and you can see any of the other 200 plus such conversations we’ve had.
We love your comments, feedback, and suggestions, write to us at MIBPodcast@Bloomberg.net. I would be remiss if I did not thank the crack staff that helps me put together this conversation each week. Medina Parwana is our producer/audio engineer, Taylor Riggs is our Booker, Michael Batnick is our head of research.
I’m Barry Ritholtz, you’ve been listening to Masters in Business on Bloomberg Radio.