The market overpays for good news and over-discounts bad news, with great persistence. Anything we can do that counteracts that is likely to win. And anything that contra-trades against the market's most extreme bets is likely to win.
So the alpha engine for equal weight and for fundamental index is the same: It's all driven by contratrading against the market's most extreme bets. It's all driven by long-horizon mean reversion.
A fundamental index doesn't win because of the fundamentals. Fundamentals have nothing to do with it. It's because we're anchoring on some convenient, stable anchor, the fundamental size of a business, and using that anchor to contra-trade against the market's extreme bets.
InsideETFs: Does this same approach work across all asset classes, or is the outperformance confined to equities?
Arnott: Long-horizon mean reversion works across all asset classes. We have strategies in place in stocks, fundamental index; bonds, fundamental index. Commodities, Dow Jones has the Dow Jones RAFI Commodity Index. Currencies; we're rolling out a RAFI global macro strategy that's across equity, bond, currency and commodity markets. So it works across all markets. Long-horizon mean reversion works everywhere.
Now, that's not to say it works over the same time horizon everywhere or works equally well everywhere. But it does work everywhere.
Every one of these markets is populated by human beings. And a funny thing about human beings is they all have emotion, and they all tend to overreact. What a shock that is.
Inside ETFs: There's been a lot of talk recently about diversification and moving away from the nine style boxes and using factors as a new way to build a core portfolio. What are your thoughts on that as a new way for investors to build the core of their portfolio? Is that the right approach?
Arnott: I think factors are a powerful tool. I think, as with any tool, there's risk of overuse. Would you want to build a house without using a hammer? Of course not. Would you want to build a house solely by using a hammer? You've got to be kidding. So using factors as part of your tool kit, sure; it's a powerful tool. But using it as the singular, the central approach to investing? You've got to be kidding.
We're writing a series of papers this year called “Alice in Factor Land.” And we point out in the first paper in that series, which is coming out shortly, the incredible shrinking factor return. We point out that the returns on factor long/short paper portfolios don't show up in mutual fund and ETF data. The returns for factors that are realized in mutual funds and ETFs are much smaller than the returns that exist in the paper portfolios.