This is the final installment in a series of interviews with some of the most influential people in the field of indexing and index-based investment. The interviews are also published in the November/December 2014 issue of the Journal of Indexes.
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. Global assets tied to Research Affiliates Fundamental Index strategies stood at $131 billion as of Sept. 30, 2014. Arnott is a fan of indexes, for certain, but the best indexes, in his opinion, don't rely on market capitalization.
How much further do you think indexing has to go before it hits critical mass? Or do you think it's already arrived?
I'm not sure what "critical mass" means. In theory, conventional cap-weighted indexing could span 100 percent of the market. Of course, then there would be no price discovery. But alternative indexes like the RAFI Fundamental Index, like the full array of smart-beta strategies, can be much, much, much bigger than they are now.
Collectively, we estimate money tracking smart beta to be about $300 billion to $400 billion. How much of the world stock market is that? Not even 1 percent. So, this is an arena where substantial additional growth is entirely possible.
Cap-weighting, on the other hand, is a very mature business, and if you want to own the market, you must cap-weight. So, there's nothing wrong with cap-weighting. It's a very legitimate, "I don't want to play the stock-picking game anymore" kind of strategy.
How do you define "smart beta"?
Well, "smart beta" is merely a label for a category of strategies, and it's early days yet, so the meaning of "smart beta" is shifting. It's also a very popular category of investing, seeing a lot of flows, and so everyone wants to jump on the bandwagon and say, "We do smart beta too," or "We've been doing smart beta for decades."
"Smart beta" to me, if it's defined broadly enough to encompass everything except cap-weight, is also broad enough to be a totally meaningless term. To be meaningful, "smart beta" should begin with a core principle that you studiously sever the link between the price or the market cap and a security's weight in the portfolio so that the weight of a company will not go up just because the price went up. That's the heart and soul of Fundamental Index alpha and my definition of "smart beta."
There are other elements that I think are important: It should have low turnover, good liquidity, be broadly representative of the aggregate market or the aggregate economy, and so forth, but I would give a pass to anyone who uses the label "smart beta" if it severs the link with price and has most of the other attributes.
You've developed fundamentally weighted indexes for stocks, bonds, commodities and REITS. What do you see ahead for smart-beta benchmarks?
Well, first, very few people use fundamental indexes as benchmarks. If you're running a strategy, you want a benchmark that's easy to beat. The Fundamental Index performance is not easy to beat. So, very, very few people use it as a benchmark. Lots of people use it as a strategy. Are there going to be additional developments in smart-beta strategies? Absolutely.
Are there going to be exciting new variations on the Fundamental Index methodology as a smart-beta strategy? Absolutely. We just rolled out a fundamental low-vol [index] with FTSE. At the end of last year, PIMCO rolled out our RAFI low-vol strategies using portable alpha. These are really exciting developments.
We intend to continue to be major contributors to innovation in the world of investing and in the world of "smart beta," but there are going to be a lot of other people with good ideas, and that's exciting. The most personally exciting thing about the Fundamental Index approach was not that it has been such a success—although that is very exciting—it's that it opened the door for a lot of other good ideas. Equal weighting has been around for ages but never could gain traction. Minimum variance has been around for ages, and never gained traction. By saying, "You know, we don't have to index by market cap or by price, and doing so might actually hold down your returns. Severing the link between price and the weight in the portfolio may be a tremendous and reasonably reliable path to incremental returns," all of a sudden, the whole spectrum of ideas that severed the link between price and weight in the portfolio blossomed, leading to tremendous growth opportunities for these smart-beta strategies.
I've seen the term "quasi-active" thrown around in reference to smart-beta indexes. Do you think that's an accurate term?
Absolutely. If you view the Fundamental Index strategy or any of the smart-beta strategies through the prism of finance theory—which centers on the cap-weighted market as the starting point for everything—they are all active strategies. They don't actively choose stocks based on some analyst's view; they choose stocks based on some algorithm. And if that algorithm severs the link between price and the weight in the portfolio, it appears through extensive historical testing, which adds about 2 percent per year all over the world, spanning decades. Well, that's cool. And it doesn't have to be the Fundamental Index method, it can be darts.
So, are these strategies active? From the vantage point of the market, which is cap-weighted, of course they're active. Turning it around, is the market active relative to the economy? Absolutely. The market is making enormous active bets on which companies are going to be extraordinary in the years ahead. Look at Facebook, Tesla, Twitter. They all carry valuations that would require monumental growth in the years ahead merely to justify current prices. Is that growth going to happen? Sure it could, but the market is already betting that it's a foregone conclusion, so the market is making big active bets, not relative to itself, but relative to the broad macro economy.
The Fundamental Index looks passive relative to the macroeconomy, and active relative to the market. The market looks active relative to the macroeconomy, and by definition, passive relative to the market itself.
What do you think that investors should be concerned about in the current economic environment?
The main thing they should be concerned about has nothing to do with indexing or the Fundamental Index strategy and everything to do with long-term, forward-looking growth. With an aging demography, productivity growth will slow down. With population growth, especially in the working-age cohorts, shrinking GDP growth has to diminish. So if we demand that our policy elite deliver 2 to 3 percent real economic growth, we're demanding the impossible; it's not going to happen. And if we demand that stocks deliver 10 percent returns from a starting point of a 2 percent dividend yield, it's not going to happen.
There needs to be a radical ratcheting down of expectations for macroeconomic growth and for stock and bond market returns. People need to ratchet down expectations and plan on relatively low returns.
If you ratchet down your expectations, you'll save more, spend less and plan on working a little longer. Far too many people are reluctant to ratchet down their expectations and, sadly, far too many people in our industry prosper by telling people what they want to hear. By reinforcing the notion of robust future growth and impressive future returns, yes they garner more business, but their customers set themselves up for grave disappointment.
How should investors be addressing the current low-rate environment in their portfolios? You may have already answered that.
I partly touched upon that. Let me tackle that question in a different way, too. Investors generally have large allocations to mainstream stocks and mainstream bonds. They generally have too little allocated to liquid alternatives and even illiquid alternatives that can: a) diversify their risk; b) seek returns in low-correlation markets; c) seek out markets with higher yield or higher growth or both; and d) perhaps most importantly, provide some participation in inflation, because mainstream stocks and mainstream bonds tend to get savaged by inflation.
So, what we're looking at is a whole spectrum of asset classes, what we call the "third pillar," where the first pillar is mainstream stocks, and the second pillar is mainstream bonds. Most people have far too little in the third pillar, which consists of obvious inflation hedges like TIPS, commodities, and REITs, and less obvious inflation hedges such as emerging market stocks and bonds, and high yield—all of which fare very nicely in an inflationary regime.
I'm not saying investors should have all of these asset classes all of the time. I'm saying all of these asset classes should be part of an investor's tool kit, and seriously considered for significant allocations whenever they are attractively priced. And if investors do that, they're likely to have a much smoother ride into an uncertain and slow-growth future.
How do you think ETFs have changed the indexing industry?
ETFs have been very important in changing investors' views on liquidity of indexes, the role of indexes and intraday trading, which are now a very legitimate part of an investor's tool kit without having to trade individual stocks and bonds. That is marvelous.
The favorable tax treatment adds another marvelous advantage. In the indexing arena in particular, including smart beta, capital gains distributions in ETFs are minimal. Well, that's nice. So, ETFs have changed the landscape of the indexing world and, more broadly, of the investment world in general, opening up a whole new array of possibilities.
I recall Jack Bogle once likened ETFs to giving gasoline to an arsonist because intraday trading is, in his view, very dangerous. Well, what about daily trading at daily net asset value? It's not that different. If people want to be able to do something, they will; and if they do something that they're not very good at, well, it's a free market and a free economy. Some people are good at it, and having this tool available to them is wonderful.