Arnott: Emerging Markets Look Attractive

July 19, 2013

In an investment world that should be about expected returns, emerging markets haven’t looked this good in a long time, Rob Arnott says.


While many investors have been fleeing positions in emerging markets, they should probably be doing exactly the opposite, according to Rob Arnott, founder of the pioneering fundamental indexing firm Research Affiliates. In fact, Arnott told Managing Editor Olly Ludwig that the opportunities for investors in developing markets probably haven’t been this good since the nadir of the stock market collapse in 2009.

Arnott’s Newport Beach, Calif.-based firm is behind the indexes in six upcoming Schwab ETFs as well as nearly three dozen PowerShares ETFs that together now have $5 billion in assets. He also spoke to something we’ve been noticing here at IndexUniverse; namely, that investors seem very clearly to be warming up to fundamental indexing methodologies that go beyond cap weighting. I'm detecting that fundamental indexing is getting some traction among advisors and investors.

Arnott: It is getting traction. When we first rolled the idea out eight years ago, the reaction ranged from active interest to skepticism to derision to outrage—the whole spectrum. And the outrage was mostly centered on our calling it an index. The outrage might have emanated from Valley Forge, Pa., no?

Arnott: It was across the board. The whole indexing community was outraged that the word “index” could be attached to something that was not cap weighted. But that’s just semantics. And what's happened since then is very, very interesting. Value investing, since 2007, has been a disaster all over the world. It’s underperformed in the U.S.; it’s underperformed in international markets; it’s underperformed in small-caps; it’s underperformed, even in the last five years, in emerging markets, which is an area where value never underperformed.

And so, how has Fundamental Indexing done since 2007? It has added respectable value, not huge, but respectable. So the early critics said, firstly it’s a backtest—have you ever seen a bad backtest? And secondly, it’s a value strategy in drag. It’s going to work when value works, and it won't work when value doesn’t. OK, it’s worked when value hasn’t. Now, to be sure, when value has been hit hard, we’ve underperformed. But every time value has a modest snapback, we have a big snapback. When you talk about underperformance in this context, it’s relative to cap weighting, right?

Arnott: Correct. And so the markets are basically validating the idea and saying: “The worst thing you could say about it is that it’s the best value strategy to come along in a long time.” How do you describe it to a layperson so they can get their head around it?

Arnott: Do you want a portfolio that resembles the look and composition of the broad macro economy? Or one that is weighted to most heavily rely on safe havens, trendy growth stocks, momentum stocks—a portfolio that’s popularity-weighted. You tell me which you’d prefer.

And so, Fundamental Indexing, viewed in that context, does look something like an index, an index that studiously seeks to match the composition of the macroeconomy, not one that seeks to match the look and composition of the stock market.



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