Chicago – In this burgeoning era of smart beta and multifactor investing, Rob Arnott argues that, at the end of the day, it all boils down to value.
The chairman of Research Affiliates, speaking Tuesday to roughly 1,700 advisors and active wealth managers at the Morningstar Investment Conference in Chicago, said that markets are always looking for inefficiencies, but “there are some timeless inefficiencies” that are more dependable, and reliable. Value is one of them.
The value effect—“the granddaddy of all factors”—or stocks with low price-to-book ratios beat growth stocks by about 2.5% a year for the past 50 years, according to him.
Year-to-date, that’s still holding true. Consider the performance of the $21.8 billion Vanguard Value Index Fund (VTV | A-100)—a strategy that uses price-to-book ratio, forward price to earnings, historic price to earnings, dividend-to-price and sales-to-price ratios to determine value—and the $21 billion Vanguard Growth Index Fund (VUG | A-92), which selects stocks based on six growth factors:
Chart courtesy of StockCharts.com
“Value has a structural alpha,” Arnott said. “That structural alpha works for long-term investors. But does that mean it works all the time? No.”
Behavioral Challenge For Investors
And that’s what the challenge is. From a behavioral perspective, value investing can be difficult to stomach because cheap stocks usually got that way following “horrible” recent past returns. Pricey stocks, on the other hand, have great past returns.
“George Soros famously said investing is painful. Correct investing is painful. We are human beings and we want to buy low and sell high, but we can’t do it,” Arnott said. “The essence of successful investing is fighting against human nature, which is why I think value is the most important factor.”
“The message is simple: You buy a stock, ask ‘what am I paying for it?’ You look at an asset class, ask ‘is it trading rich or cheap relative to historical norms?’ Same with smart beta or any other strategy,” he said.
Factor Diversification Key
And there’s another risk to subscribing to Arnott’s value-first message, said Cliff Asness, founder and chief investment officer of AQR Capital Management. Factor investing, according to him, needs to be put in the context of a broader portfolio for it to work. Investors need to prioritize diversification, he said, and that could mean owning factors—profitability, for instance—that are often richly priced.
“Value works, but it’s a wild ride,” said Asness, who was at one time a teaching assistant for Prof. Eugene Fama. “Sometimes fundamentals come in and value is wrong. Sometimes markets are right.”
“That’s why factor diversification is important,” he said, noting that at his firm he likes value, momentum, low beta and—more recently—profitability. “Profitability is negatively correlated to value, for example, and the power of diversification mostly trumps timing.”
His core belief is that when it comes to managing money, it’s important to remember that markets are highly efficient in a broad long-term sense, but they are nowhere near perfect. If you invest for the long term, “I’d prefer diversification than [factor] timing,” noted Asness.
Contact Cinthia Murphy at [email protected].