Arnott: It’s Relatively Easy To Beat The Market

May 04, 2017

One could easily make the argument that Rob Arnott, founder and CEO of Research Affiliates, is the face of smart-beta indexing. In addition to his firm's own indexes, he has partnered with index providers such as FTSE, Russell, S&P Dow Jones Indices and Citigroup to create benchmarks based on his research, and frequently appears at conferences and in the media to speak about the Fundamental Index concept.

In the run-up to the 2nd annual Inside Smart Beta conference June 8-9, 2017 in New York, InsideETFs' Head of Europe John Swolfs sat down with Arnott to discuss the current state of the "smart-beta union.”

Inside ETFs: What was it about cap-weighted investment strategies that didn’t appeal to you, that made you look in a different direction for an alternative way to invest?

Rob Arnott: While capitalization weighting makes an assumption that market prices are correct, intuitively they're not. The price of any stock represents its fair value, plus or minus an error. The market may judge the price too high, it may judge it too low. The market is constantly trying to figure out whether the price is too high or too low. In the very long run, the errors are mean-reverting; they correct over time, creating the challenge of how do you do better than that.

And what's interesting is in the smart-beta arena—at least by original definition of smart beta—the engine for all of these strategies is the same: It's a rebalancing of alpha. You're contra-trading against the performance chasers, the lemmings. And isn't that cool, to have a strategy that will contra-trade against the performance chasers?

So that's why I reject cap-weighting, and that's why I believe that for the patient, long-term investor, it's actually relatively easy to beat the market.

Inside ETFs: You stated you think patient investors can easily outperform traditional benchmarks. Do you feel that traditional benchmarks of the S&P 500 or a Russell 2000 are a fair comparison for factor or smart-beta strategies?

Arnott: That's actually a trickier question than it sounds. The market is cap weight. So people will always want to know, is this idea going to add value? And adding value, for most people, means adding value relative to the market.

In the early days of fundamental index, we were encouraging people to use it as a benchmark. Our rationale was simple: If you have a dual benchmark, cap weight and fundamental index, you're going to find that most of your managers fail to beat fundamental index. And you're going to be drawn toward making greater use of fundamental index, or other smart-beta strategies.

That effort fell flat on its face. Nobody wants a benchmark that's hard to beat; nobody. So we quickly realized that if you recognized that investors really just want to beat the market, it's OK; if your benchmark is the market, it's OK. In addition, you aren't seeing a push from the factor community to shift the benchmark.

 

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