Arnott: Emerging Markets Still Look Good

Rob Arnott’s Research Affiliates can now boast about $60 billion in assets that use “fundamental” indexes from his Newport Beach, Calif.-based company that screens stocks based on book value, cash flow, sales and dividends. One wonders if the future of indexing will feature Arnott more and more. When IndexUniverse.com Managing Editor Olly Ludwig sat down with Arnott in his office, they talked about his disagreement with indexing legend John Bogle, the state of the ETF industry and the allure of investing in relatively debt-free emerging markets countries.

Ludwig: When we talk about the pioneers of indexing, there are those who say that the baton must be passed at some point, and that perhaps you represent the next chapter. How do you respond to those views?
Arnott: Well, I have enormous respect for Jack. He is one of my heroes in this business. He is one of the pioneers. But as with so many pioneers, the ideas that spawned his and Vanguard’s meteoric success—that if you hold costs down, the customer gets more; and that since departures from the market are a zero-sum game, you should just hold the market—are very powerful ideas. But as with so many pioneers, he latches onto those ideas tenaciously and defends them fiercely. And so to him, Fundamental Indexing is active management in drag.
Ludwig: I was going to say you are in his cross hairs in some sense.
Arnott: He and I are friends. But this is one area of fierce disagreement. Another is ETFs.
Ludwig: Let’s start with the “active management in drag”—I love that formulation—then we’ll move on to ETFs.
Arnott: OK. Viewed from the perspective of classic cap-weighted indexation, Fundamental Indexing is active management. Any departure from cap weight is active management, viewed from that perspective. What a lot of people miss is that there's another perspective. Viewed from the vantage point of the macroeconomy, the cap-weighted market is making huge active bets. During the Internet boom, Cisco was 4 percent of the market, when it was 0.2 percent of the economy, and that’s a huge active bet. And so viewed from that perspective, Fundamental Indexing is studiously seeking to mirror the look and composition of the economy and using it as an anchor to contra-trade against the market’s constantly changing views, expectations, speculations, fads, bubbles and crashes.
That’s the elegance of Fundamental Indexing. Viewed from the vantage point of the macroeconomy, Fundamental Indexing does its best to be passive. And cap weight winds up loading up on growth companies, safe havens, weighting companies in proportion to their popularity.
Ludwig: So there's a whole lot of nuance here that we’re not getting from Jack Bogle? For example, I’m guessing you’ll concede the point that the line between active and passive management has blurred in the last two decades.
Arnott: It’s gotten blurrier and blurrier. And Fundamental Indexing has helped to make it even more blurry.
Ludwig: So you don’t dispute Bogle’s assertion that Fundamental Indexing is “active management in drag?”
Arnott: Actually, I don’t. I accept the notion that, from a cap-weight-centric world view, it is active management in drag. But I take it a step further, and I say: “That’s not the only world view.” From an economy-centric world view, Fundamental Indexing is passive and cap weight is active. It’s a little like looking at the world with one eye, or the other eye or with both.



Ludwig: Let’s talk about your disagreement with Bogle regarding ETFs. I've heard him rail against ETFs. Interestingly, Vanguard’s own data don’t substantiate his point of view that people trade ETFs too much. Maybe it holds true for other fund sponsors, but for Vanguard it doesn’t. Yet he asserts their people are using that intraday tradability of ETFs and misusing it and hurting themselves. Is that something with which you agree?
Arnott: I don’t disagree. I think you can turn intraday and hurt yourself badly. I view ETFs as exactly what they are—mutual funds that you can trade intraday. Now, Jack has likened ETFs to giving kerosene to an arsonist. To be sure, you can do yourself serious damage. ETFs are a tool. Dynamite is a tool. Would the world be better off without dynamite? No. Should ETFs have a warning label? Yes. Should people use them carefully? Yes. Can you hurt yourself badly if you misuse them? Yes.
Ludwig: Are you suggesting that that disclosure is insufficient?
Arnott: No. There is ample disclosure. I think we’re over-regulated. But be that as it may, you’ve got to recognize that when you're dealing with adults making decisions for themselves, they have the primary responsibility to make decisions that avoid hurting themselves. And do ETFs create a greater opportunity for doing so than conventional mutual funds? Ever so slightly, yes. But people want that ability to choose their entry and exit points.

Ludwig: In this active vs. passive debate, I have conversations all the time where I'm preaching the gospel of indexing—buy, hold and rebalance. But I’m continually astonished that people, by and large, cannot believe that the guy from Harvard Business School can't beat one of Bogle’s cap-weighted funds year after year. And here’s my question: Does it make it easier for you to make your case for Fundamental Indexing by leveraging its incremental move in the active direction in such a manner as to kind of set the hook a little bit more?
Arnott: People intuitively know, unless they have a Ph.D. in neoclassical finance theory, that the market doesn’t always get it right. And if the market doesn’t always get it right, what could make more sense than to contra-trade against the extreme bets? This idea has gained very little traction in university endowments. Usually there is a famous professor on the board who will say, “It can't be this easy.” But it’s made huge traction in retail and in jumbo public funds, where they're familiar with indexing. And they're very frustrated at where cap-weighted indexes have led them astray.
Ludwig: How do you respond to a generic, if not fully informed, objection to your strategies? I’m thinking of PowerShares, because they certainly seem very committed to what you're up to. But their funds are more expensive than Vanguard funds, for example.
Arnott: My response to that is pretty straightforward. Which is overpriced, 10 basis points for assuredly minus 10 basis points alpha, or 40 basis points for an alpha that, over long periods of time, appears to be about 2 percent of outperformance per year?
Ludwig: So that 2 percent number is still in sharp focus?
Arnott: What’s interesting is, no, it hasn’t achieved S&P 500 plus 2 percent. It’s achieved S&P plus 1.2 in an environment in which value underperformed growth by 1.5 percent a year. So, if value is underperforming by a pretty solid margin, and we’re adding value, imagine how we’ll do when we get back to a normal environment where value typically wins.



Ludwig: So, when someone says, “Rob, this is just value investing in disguise,” would you say, “Bring it on. That’s exactly what I want you to say”? Or is it more nuanced than that?
Arnott: Well, that would be part of it. The other part of it is, isn't it amazing that, with value underperforming by 1.5 percent a year, this has beat the market by 1.2 net of all costs? That’s cool.
So to those who say it’s expensive, I would say, “Expensive relative to what? Expensive relative to index funds that add no value, incur trading costs, incur fees and therefore surely deliver the index minus a little? Only if you care solely about price. Expensive relative to active managers who charge 1 percent or more, and, on average, who deliver S&P minus 1 or 2 percent? Boy, that’s an easy comparison. And, relative to alpha? No, it’s cheap.”
So I view the pricing as very reasonable. The other element here is more nuanced. If somebody has a good idea, should they garner some rewards for it? And if we’re collecting 3 or 4 or 5 basis points—a nickel or less for every $100 somebody puts into one of these funds—is that unfair? So there is a fairness issue, too.
Ludwig: I wanted to ask you about the ETF industry, per se. There is a perception that’s developing now that growth is starting to slow down. The launches are slowing down. We watch the filing traffic going into SEC rather closely, and it seems to be slowing. Would you comment a little bit on your perception of where the industry is in terms of overall development?
Arnott: The industry is maturing, by which I mean we’re moving away from the stage of throwing spaghetti on the wall and seeing what will stick. We’re in the stage where product ideas have to make business sense. And we’re seeing that across the board. Now that doesn’t mean the innovation slows. It means the innovation gets more focused, more concentrated. You can still throw spaghetti on the wall if you're far enough out of the mainstream, and you have a distribution partner who is willing to give truly out-of-mainstream ideas a new try.
But ultimately, that notion of, “We’re in an entrepreneurial startup business and profits don’t matter as long as there is visibility to profits three to five years out,” that’s changing. The margins in this business are tight. The fees are squeezed.
Ludwig: OK. Now, let’s turn to your broad thinking and the three “D’s,”—debt, deficit and demographics—that I’ve read from you and heard from Jason Hsu. What is your perception about where things stand in a macro sense right now?
Arnott: Well, you’ve got deficit and debt playing out as a slow-motion train wreck across the developed world, and that’s going to be causing severe challenges for the coming decade. You’ve got demography as a longer-term backdrop. In effect, my generation has made promises that our kids and grandkids can't possibly afford to honor. And we declare them to be sacred-trust promises that we made to ourselves, that we expect our kids and grandkids to honor.



Ludwig: And you're saying this is simply not a sacred trust, and at some point we have to face that?
Arnott: These are not sacred trusts; they're promises that we made to ourselves without consulting our kids and grandkids and without prefunding. And we can't afford it anyway. So those deals have to change. And what we’re seeing in Europe are two things: Firstly, a profound reluctance to embrace the notion that—to borrow from Clinton’s campaign—it’s the spending, stupid. You and I can't spend money that we don’t make, not for long. And a country can't spend money it doesn’t make, not for long.
And so the spending has to come down to match tax revenues. There's no room in Europe to raise taxes and expect it to deliver higher tax revenues. Hollande’s hike in the top tax rate in France is not going to deliver more revenues; it’s going to deliver less. And most economists—even reasonably left-leaning economists—would say, “It’ll deliver less revenues.”
Ludwig: Because?
Arnott: Because, to borrow from Milton Friedman, few things in the world are more mobile than the affluent and their money. And so, if you can't close deficits with higher taxes, you have to close them with lower spending. We’re seeing a profound reluctance to acknowledge that with aging baby boomers in Europe—who are older than here and aging faster. The promises made to those boomers, by themselves, can't be honored by their kids and grandkids. There aren't enough of them.
So this is a slow-motion train wreck. The way it plays out is very simple: Spending will match tax revenues at some point in the not-too-distant future, sometime in the next several years. What we’re seeing is the political back and forth to find the path of least resistance to get there.
Ludwig: Yes, they're still playing out. So, if you're an investor, given this drag, clearly on the developed world, it doesn’t mean everything comes to a halt.
Arnott: Of course it doesn’t mean everything comes to a halt.
Ludwig: There are still investment opportunities, even in the developed world?
Arnott: Yes.
Ludwig: So, what’s most prospective now?
Arnott: Emerging markets, for the most part, don’t have large deficits; for the most part don’t have large debt burdens. Not because they wouldn’t be willing to have large debts, but because the markets won't let them. The debt burden of the emerging economies is 10 percent of the world total. For the G5, it’s 70 percent. Both represent 40 percent of world GDP. So one has seven times the debt coverage ratio of the other. Which would you rather own?
Ludwig: It would appear to be emerging. What about China—that country isn't without its problems, right?
Arnott: Well, you can't buy their bonds, anyway. And when people talk about China and the risk of a hard landing, if you push them and ask, “What do you mean by a hard landing?” The answer is that their growth could be less than 5 percent. We should be so lucky as to have that hurdle.
Ludwig: Right. So emerging markets are still worthwhile? And both stocks and bonds?
Arnott: Right. But global diversification has powerful merits.