James Gard: Welcome to Morningstar. I’m delighted to have in studio with me Rob Arnott. He is Founder and Chairman of Research Affiliates. Thanks for joining today Rob.
Rob Arnott: Thanks for the invitation.
Gard: So you are about to give a presentation to Morningstar staff and the headline is Demystifying Financial Markets. Can you elaborate and give us a bit of a tease about what you’d be discussing?
Arnott: We are in an industry plagued by two mistakes that are deeply rooted in human nature. One of those is performance chasing. Whatever is newly cheap got there by inflicting pain and losses. And so it goes very much against human nature to say, oh good, I lost some money. Now I can buy more at this lower price.
Demystifying Financial Markets
Arnott: By the same token, it goes against human nature to sell what’s newly expensive because it gave us great joy and great profit. The second mistake that is pervasive is impatience. There are lots of measures that are very helpful on five and ten year returns that can help us identify what’s attractive and what’s a sensible investment. But very few that work on a horizon of a year or less. And most people have patience that a year is the outer bound of that patience. So this is the fascinating part of investing that investing successfully long term is actually not difficult at all. Investing successfully short term is very difficult and human nature conditions us to do the wrong thing at the wrong time.
Gard: Yes. You’ve previously spoken about market narratives and I’ve watched on TV last year talking about benign market narratives in terms of the AI revolution. Looking back at that now, has that market narrative been dismantled in terms of where AI is going and evaluations or is this a temporary bout of volatility, do you think?
Will AI Change Everything for Investors?
Arnott: There are always temporary bouts of volatility. Markets will always be volatile to varying extents, a little volatile to a lot volatile. That’ll never change. The interesting thing about narratives is that narratives shape markets and move markets. Or I should say changes in narratives move markets. Narratives have the advantage of being largely true and the disadvantage of being entirely reflected in current share prices. So the narrative today is AI will change everything. It will eliminate millions of white collar jobs, highly skilled jobs. It’ll create millions more for those who know how to use AI to leverage their own time and their own capabilities. That’s true. AI is the real deal. Now AI has been around for a long time. I was doing neural networks in the 1980s.
Gard: Okay.
Arnott: But what is new is user friendly AI. You can talk to it. And it is the real deal. Our CEO about 10 days ago had a conversation with ChatGPT about how AI fits in the history of human evolution. And the response that came back from ChatGPT, when I read it, I was to use the British expression gobsmacked. It was profound, insightful, succinct, thoughtful, detailed and fascinatingly expressed with words that conveyed passion from a machine. And I finished reading it. I thought I would have been totally unsurprised if this was written by a double PhD in anthropology and philosophy. I’m absolutely astonished that it was written by a machine. Actually, I’ll send it to you afterwards.
Gard: Fantastic.
AI Is the ‘Real Deal’
Arnott: You can post it on your website. It’s fascinating. So it’s the real deal. But the markets are about money. The markets are about profits and success. And we have chip makers that are minting a billion, two billion a week, three billion a week in profits. Their customers are the Googles, the Amazons, the Metas of the world. Their customers have to be happy customers. And those customers have to have happy customers. Each step along the way has to be able to monetize it. So the chip makers are minting money. They’re monetizing. The next level down is trying to figure out how to turn this into a profit stream. Human nature embraces technological change gradually and grudgingly. And so these changes never happen as fast as the pioneers expect. They usually go further than the general public expects, but it takes longer. And the thing that’s missing from most of the current narratives is that the leaders of today are not necessarily the leaders of tomorrow.
Gard: Right.
Arnott: Disruptors get disrupted. OpenAI had what was considered a commanding lead in large language models, and then all of a sudden DeepSeek comes out of nowhere. And with one-one hundredth the resources of OpenAI creates a product that’s just as good as ChatGPT 4 almost as good as 4.5. I’m not an expert on AI or the interactive AI tools, but I am familiar with technological disruption and technological disruption is the norm.
Gard: So, how, I mean, I’m looking at your slide deck in terms of the top dogs of one year changed so much ever since the 1980s and I was looking at the year I was born and the top dogs then are so different from now. So, how does that aline with your work on sort of the way you think about indexes and the way they’re constructed. You talked previously about breaking the link with price and you have expressed concerns about the super concentration in this field.
Exploiting Inefficiencies in Index Investing
Arnott: Indexation itself is becoming the disruptor of markets and that may be not a good thing long term, but much more important to me, it creates market inefficiencies and those inefficiencies can be exploited. So, last year, for instance, we introduced the NIXT index, the index of deletions, companies nixed from the index. And history suggests that the act of getting kicked out of an index kicks the price down even a little further so that there’s a snapback that averages over 5% a year for the next five years. Well, that’s an exploitable inefficiency. That’s fun. When we look at conventional cap weighted indexes, there are two Achilles heels. RAFI, Research Affiliates Fundamental Index addresses one of them by not weighting the stock in proportion to its price, its market capitalization. Weight the stock in accordance with its fundamental economic footprint. How big is the business? Now people will say the growth stocks, these are better companies. The value stocks, these are worse companies. So, of course, they deserve a premium price.
Yes, they do. But the good news is already in the price. It’s not going to help you unless the company exceeds lofty expectations. The cheap stocks aren’t going to hurt you unless they underperform bleak expectations. So, why not weight them according to their economic footprint? If you do that, you get a rebalancing alpha. You also get a value tilt. But the granddaddy of these products, the FTSE RAFI All World Index has beat the FTSE All World Value Index in 16 out of 18 years by an average of 2.5% a year compounded with the worst-ever drawdown being just 2%. So, I mean, exploitable inefficiencies are created by index funds and can be a gold mine.
Gard: Yes. And you sort of, I mean, as an investor, you want to buy the deletions, if you look at what’s been deleted and their immediate bounce back. So, thinking then about value stocks, you’ve written about how value stocks can be as growth-oriented as growth stocks, they’re more growthy than you think. I mean, in Europe, we’re having a bit of a value rotation and the nature of our companies tend to be more value-oriented. I mean, do you think that growth versus value debate is kind of a bit old now and we need to move into different way of discussing?
Looking Beyond Growth Versus Value
Arnott: Well, yes, we need a different way to discuss it. But also just touching on a couple of the points that you just made. The Russell value index has had earnings and dividend growth this century to date over the last quarter century, just as fast as the Russell growth index. Now, to be sure, the individual companies, the value companies have grown slower than the growth companies. But every time the value index rebalances, it kicks out some stocks that have soared in valuation, adds some new value names. And so it rotates into a portfolio that has more earnings and more dividends with each rebalance. The growth portfolio rotates into companies that drops companies that fall to more neutral valuation and replaces them with new high flyers. So, every rebalance, it’s pulling down the earnings and dividends of the portfolio. The result is that the value portfolio and the growth portfolio have had actual earnings and dividend growth that are near identical. So, the whole narrative that this portfolio is better than this and therefore will perform better is rubbish. Value underperformed growth horrifically from 2007 to 2020.
Gard: It was a bad era.
Arnott: As a lifelong value investor, trust me, it was not a lot of fun.
Gard: Yes, I can imagine that.
Arnott: But what was fascinating to watch was that the value companies were doing fine. The value stocks weren’t, but that’s because they were getting cheaper and cheaper relative to growth. Growth was getting more and more frothy. And lo and behold, right now, the relative valuation spread is in the top 2 percentiles of all of history in terms of the spread between growth and value. The snapback when it comes is likely to be stupendous.
Gard: You’ve been described as the Godfather of smart beta. Are you concerned about the movement of, say, huge asset managers into active ETF space?
Arnott: Active ETFs are the same as active mutual funds. They just trade intraday. I think this is a natural evolution of the markets. And I welcome change. Change creates opportunity. It also creates inefficiencies. So if you’re alert to possibility of new inefficiencies, there’s endless opportunities.
Gard: Excellent. Well, thanks so much for your time today, Rob.
Arnott: Thank you.
Gard: Much appreciated.
Arnott: Really enjoyed it.
Gard: For Morningstar, I’m James Gard.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
