Friday, July 19, 2013

Arnott: Emerging Markets Look Attractive

By Olly Ludwig | July 19, 2013

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.

Arnott (cont'd.): What we found is that the idea has worked very, very nicely. In the last 12 months, the FTSE RAFI All World 3000 was at a 20.7 percent return. The FTSE All World Series, the cap-weighted index, is 330 basis points behind. The MSCI All World is 350 basis points behind.
And when we look over at the Russell Indexes, the gap is almost identical. The Russell Fundamental Global is 20.6 against the others. So the idea is working.
In the U.S., it's even more dramatic. The U.S. FTSE RAFI 1000, in the last year, is up 27 percent and Russell Fundamental is up 25.5, while S&P is up 20.6 and the Russell 3000 is up 21.4. So is it really coming down to these performance metrics that are now in the bag and no longer backtested? Is that what's causing the derision to recede? Or are there other issues?
Arnott: I think there's a lot of other issues. What’s causing the flow of funds into the strategies is recent performance—this is a performance-chasing business. We’ve got to be in the only business on the planet where, when products are trading at a steep discount, client appetite evaporates. So, the flow of funds into Fundamental Indexing is largely driven by the fact that it has worked.
The evaporation of the derision is largely due to the fact that people are starting to really understand the basic principles and are starting to recognize that if you link the weight to the price, you will—pretty systematically—overweight the overvalued and underweight the undervalued.
And if you break that link, the errors in price can cancel instead of systematically pulling your performance down. People are starting to buy that. Even in the academic world, people are starting to embrace that idea. Now, when you mentioned them a moment ago, there was a very slight distinction between the returns of the FTSE RAFI series and the Russell Fundamental series. What are the differences? Clearly not huge, given the similar returns, but there must be some, right?
Arnott: Basically, the FTSE RAFI Index will have a more profound value tilt. The Russell Fundamental Index modifies the index in a fashion that mitigates the value tilt. If you look back 40 years, FTSE RAFI wins by about 10 basis points, too small to matter. And Russell Fundamental has slightly smaller tracking error. But they're basically just two different flavors of the same broad product. You now have, obviously, the existing lineup of products with Invesco PowerShares. That’s the FTSE RAFI series, right?
Arnott: Correct. And the lineup with Schwab is the Russell series?
Arnott: Yes.. Does it create any kind of difficulty for you that you have competing products that are out there with slightly different branding?
Arnott: To the casual observer, it looks like it might confuse the marketplace a little bit. But you have S&P 500 and Russell 1000 indexes that are very, very similar. One will win in one year, the other will win in another year. Everyone knows that. Everyone accepts that.

Arnott (cont'd.): When Fundamental Indexing was new, people thought there should be only one flavor. It’s a little bit like choosing between cabernet and merlot. You’ve got two similar products. And depending on what you pair the wine with, one might be better with one food, and the other might be better with another food.
But the goal is not to put out a whole array of me-too products. At Russell, they were skeptics back in ’05, ’06, ’07. In ’08, ’09, 2010, they came around. And they liked the idea. They asked us, “Can we work with you on this?” Because they didn’t want to come out with a product that might make some serious blunder in its design. They knew that we knew as much about the topic as anyone on the planet. So they wanted to work with us. And the synergy there is that you benefit from their marketing muscle and they benefit from this laboratory called Research Affiliates?
Arnott: Absolutely. How many assets are benchmarked globally to your indexes now?
Arnott: It’s about $92 billion, as of June 30. It started last year at $54 billion. So it’s grown from $54 billion to $92 billion in 18 months. It’s fun seeing that the idea works well enough that people eagerly embrace it. It’s been good business for us. I mean, we’re not exactly hedge fund managers. So it’s not as if our product, even though it performs better than hedge funds, is priced at 2-plus-20! But I like to joke that a handful of basis points on a large enough asset base can be a pretty good business. Let’s talk a bit about Charles Schwab. It’s on the verge of rolling out six fundamental products that use your indexes, but with the Russell brand name. Can you share some thoughts about what kinds of things you're thinking about as this launch approaches?
Arnott: People can do Russell Fundamental or FTSE RAFI. If they're already deeply wedded to the Schwab platform, they have an easy place to go there. It broadens the toolkit. What about the vast distribution power of that Schwab platform?
Arnott: I don’t know what I'm allowed to say. I think I can comfortably say they're a distribution powerhouse. And it’s been a complete pleasure working with them on the mutual funds side. And I think it’s going to be great fun working with them on the ETF side as well. I view them as complementary products. To the extent that if one of us achieves success, there will be still a real success for the other.
This is one of the interesting things with FTSE and Russell. Russell’s distribution successes have actually served to accelerate FTSE’s growth in this area and vice versa. It's wonderful to see that take hold. Anyone in a marketing MBA program would predict that to happen. You go from one competitor to two, both will grow faster. Interesting. Any other thoughts you might want to share that I've not even come close to touching upon?
Arnott: Well one thing that I think is fascinating is we’re in a business where customer demand evaporates as soon as there's a bargain.
What's going on with emerging markets, you’ve got emerging markets trading at a Shiller PE ratio of 13 when U.S. stocks are at 24. Back in 2007, emerging crested at 37 Shiller PE at a time when U.S. was at 26. So it's been a complete about-face, from an 11 points higher price to 11 points lower price. And now people are scared of putting money into emerging markets. To me, this is a wonderful-—this is the closest thing to low-hanging fruit I've seen in the global stock market since February 2009. Right. It’s all about expected returns. And they sure outsize there in the emerging markets, is what you're saying, right?
Arnott: Exactly. And most investors simply extrapolate from the past. Emerging markets have been pretty disappointing for three years. And they’ve been downright awful for six months, and downright scary for two months. So people look at that and say, “I didn’t sign up for this. I'm outta here.”
The correct response should be, “These are interesting prices—unless I want to postulate that a China slowdown turns into a China meltdown, and conflict in Syria and Egypt turns into a Middle East conflagration; are those things possible?” Of course they are. That’s why we’ve got bargains. Are they likely? Maybe not. Are they likely to have an effect that spans the whole emerging economy of the world? Absolutely not. But it’s affecting pricing all over the world.
Now, add to that the fact that growth has beat value in emerging markets by upwards of 1,000 basis points this year to date, and a Fundamental Index is looking really cheap. Fundamental Indexing for emerging markets is currently priced at a 9 Shiller PE ratio. And are the numbers apples to apples when you look at the Shiller PEs? Or do they have a different scale altogether?
Arnott: Well, a Fundamental Index clearly has a value tilt. So the presumptive growth rate is going to be slower. But the valuation multiple is one-third off of a market that’s already nearly half off relative to the U.S. To me, that’s a really easy investment choice. It’s not a comfortable one, but you don’t get rewarded for comfort.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.