Is “Smart Beta” A Good Strategy For You?
Will Value Investing Become The Norm?
In a January 30, 2016 interview, Rob Arnott, Chairman and CEO of Research Affiliates, questioned the value of many new Smart Beta strategies, supported staying the course with value investing, and predicted that oil prices will continue to fall.
Arnott said there is “Nothing smart about Smart Beta if you adopt strategies that are overpriced.” He said 458 articles have been published in the past five years about factors that produce superior returns. He said many of these factors “only work because you are data mining.” If a factor gets popular, more people invest and the price rises, which makes that factor outperform. Arnott argued that many such strategies are “Classic performance chasing” and “most will revert to historic norms.” Such strategies are “Leading investors down a garden path to investments with the highest recent performance, but the worst perspective performance.”
Arnott believes with “really rich” spreads, high-yield bonds could be an extremely profitable investment, unless the future sees a high number of defaults or if spreads widen even further, creating even deeper bargains. He believes the odds of the former are “very long, but the latter is very possible,” so the best strategy is to average in on bonds.
Arnott warned, “The thing that is crucial is not to throw in the towel when value investing is out of favor.” He argues that the more out of favor it gets, the more the spring is coiled for future performance, and “the recoil can be profound when it turns. . ..I look on this as an extraordinary opportunity to put value into your portfolio.”
He recommends destroyed currencies, such as the Canadian and Aussie dollar, even though it is “very hard for people to do that, and even harder to stay the course when things get worse.” The recent three-year period when value investing has been savaged has been “the longest in his experience, except for the 1996-2000 the longest tech bubble.” Investors are terrified of buying emerging markets. He does not want to be an enabler of bad behavior for his clients, so he tries to convince them to stay the value investing course, which has led to a long-term record that “is pretty darn good.” His fund is the Schwab Fundamental Index Emerging Market Strategy (FNDE).
Arnott argued that zero interest rates transfers wealth from savers and investors to enable government spending. “Government spending is never as productive for macroeconomic growth as private investing.” Lowering interest rates, he argued, “Discourages investing, (and) guarantees sluggish long-term growth.” It is “extremely tempting” and “massively popular” to lower interest rates, since in the short term the free money flows into the market and markets rise, but it is a “terrible” policy. He believes the Chinese will also devalue, since “They look after their own interests, don’t we?” When China devalues 3% or 5%, they are heavily criticized, yet we devalue 20% and no one says much at all.
Arnott believes “Governments are going to have to inflate their way out of debt.” Inflation, he said, is a tax on wealth and labor. “It’s a terrible policy, but it’s terribly tempting,” because inflation decreases debt, which governments must reduce. With Japan, Europe, the UK, and US all targeting 2% or more inflation, Arnott predicts that rising inflation is “highly likely to happen.”
Arnott pointed out that the S&P without the FANGS showed a negative return last year. Most stocks were down this past year. He warned that when the US stocks crater, emerging markets aren’t going to rise. He believes they will also decline. However, he predicts, “The snapback can be huge.”
Arnott said a 60/40 portfolio is yielding about 2.3%, which is a terrible long-term rate of return. A blend of emerging markets stocks and bonds, and high-yield, yields about 7%, three times that of a 60/40 portfolio. That 5% gap is the highest since 1998, which was followed by the end of the tech bubble and the start of a three-year bull market collectively in diversifying markets, while the US was crashing.
Emerging market currencies have swung from a 25% premium to the dollar to a 25% discount in the past four years. Therefore, Arnott said, “Momentum favors the dollar,” but emerging market currencies are really cheap, so at some point those will turn. He recommended having “a large exposure when the turn happens.”
Turning to the carnage in oil, Arnott said, “People love to extrapolate past direction, and that gets them into trouble.” He also said, “People try to call the bottom again and again and again on the way down.” He argued oil prices are based on supply and demand. Oil reserves hit an all-time high in the US recently. With the price of oil falling, major producers such as Saudi Arabia and Russia will face immense pressure to pump more to make up for the decline in income or face domestic strife. Arnott believes that until there is a series of bankruptcies in the US oil belt and storage levels go down, there “will be a continued lid on oil prices to keep it from rallying.” He said oil might be higher in 3 years, but in one year? He is “skeptical.”
