Inside ETFs: What’s the biggest misconception or mistake investors make when it comes to smart-beta and factor investing? What's the biggest mistake you see across the board, day in and day out?
Arnott: The biggest mistake in every element of the investing world—and it's the same whether you're looking at equity investing, or manager selection, or mutual fund selection, or stock picking or bond investing—is performance chasing. It's endemic.
We all want more of whatever has given us great joy and profit. But that's what we ought to be thinking about selling. We all want less of whatever has given us pain and losses, but if you want to buy low, you have to buy something that's caused pain and losses. And it goes against human nature. We didn't survive on the African plains by running toward a lion. It goes against human nature.
To profit in investing, you need to be willing to buy low and sell high. And buying low and selling high means buying what's inflicted pain and losses, and selling what’s given us great joy and profit. It just goes against human nature. And it's as true in smart beta as it is in every other element of investing.
Inside ETFs: Do smart-beta or factor strategies then inherently look to take away that kind of human element of investing?
Arnott: The original definition of smart beta—strategies that break the link with price—have an inherent buy-low/sell-high discipline, because if a stock falls in price, you're going to want more of it. If it soars in price, you're going to want less of it. And so, the alpha engine for all of the true smart-beta strategies is this buy-low/sell-high discipline. That's not true of factor-tilt strategies, which are built on a foundation of cap weight.