Robert Arnott Discusses the Process Behind Research Affiliates

He thinks it's just become a marketing term. Uh. This is really a fascinating conversation. Every time I speak with Rob, I learned something new. Uh. This time I discovered that he has co authored a number of papers with the great Peter Bernstein, which was something I I didn't previously know. If you were at all interested in things like fundamental indexing, what's wrong with market cap waiting? How large that sector

can grow? The advantages of factor based investing. And I also learned that there are now over five hundreds such factors. I had no idea. I knew it was hundreds, I had no idea was that many. Uh. This is really a masterclass in this space. So with no further ado. Here is my conversation with Rob or Not. My extra

special guest this week is Rob are Not. He is the founder and chairman of Research Affiliates, perhaps best known for popularizing the concept of smart beta, better known or better described as fundamental indexing uh rafie does not consider market cap, focusing instead on four primary factors sales, profit, book, value, and dividend are not formed the firm in O two

in Newport Beach, California. Investment strategies developed by Research Affiliates, or Raphy as it's better known, manages over two hundred billion dollars in assets. Rob are Not, Welcome back to Bloomberg. Thank you. So I mentioned you started Research Affiliates and I'm used to just calling it raffi is the nickname

everybody uses. Uh back in two thousand two. Could you have imagined then that it's barely fifteen years later and your strategies are now managing over two hundred billion dollars? Did you have any expectation of how wildly successful smart data would become? Those are two different questions. Did I expect to be this successful? Yes, nobody starts a business without a healthy dose of optimism. Okay, perhaps sometimes undeserved, but but even still, that's a big chunk of change.

Did you expect to hit those sort of numbers this quickly? Um, Well, I don't know how quick that is. Sixteen years is a long time. But as for RAFI the fundamental index, UH and it's growth. I couldn't have anticipated that because we hadn't come up with the idea yet. When when did that first roll out? We first thought about the idea of indexing in non capitalization ways in two thousand three. We formalized our research and UH completed development of the

idea by mid O four. We were live with assets by the end of O four. First fund was launched by Pimco and OH five, first published index was by Footsie UM in November of oh five. So barely a dozen years. That's even faster. Scale up to not a lot of fun scale up to two and a dozen years. No, that's true, that's true, but keep in mind it's not

a hundred billions of assets under management. We licensed the idea three distribution partners, so we have the help of Pimco, Schwab, Investco, Nomura, foot See and Russell UH and couldn't get any names that anybody recognized. We keep looking, We keep hoping somebody known actually signs onto the idea. So that let's let's digress and talk about that a moment. That's a fascinating model where now I know you guys also manage money directly, not anymore, not anymore. Oh so that's that's a change

since the last time you were here. When did you stop directly managing money? We decided in two thousand fourteen that UM five of our assets under quote management close quote, where money was money that we actually managed. Fift pcent of our revenues came on that, and the tail was wagging the dog. We were winding up with distribution partners, fearful that we were going to compete directly with them. That makes sense, and we decided we don't need these complications.

Let's stick to what we're best at. And so we approached Pimco, our largest affiliate, and in effect said would you like this eight billion dollar book of business UM And they said, they said, at a price tag of zero, that's not a bad deal. I think we'll go for you. You know, if you would have come to me, I would have I would have given you the same deal they gave you. Oh my goodness, that didn't cross my mind. I wish, I wish I had thought of that. So

so this is kind of fascinating. So what I find so intriguing about your model in addition to the intellectual property, but essentially, you're in the business of licensing these indices to other people to do you know, the roll up your sleeves and do the trading, do the clients everything do which is complex and filled with risk and expensive. So you really have the sweetest part of of the pie. For us, it's the sweetest part because, uh, it's what we love to do, and it's what you you, I

ostensibly would imagine you do best. Let the other people who are experts in trading and what have you. Um I think not being involved in trading back office call desks is a wonderful thing. Um I think there are people who are really good at that, and I want them to do what they're really good at. In effect, being in the business of product innovation and licensing, we face an unusually high hurdle because our clients are distribution partners.

They don't need us, They have their own R and D teams and so for our business to succeed, UM, they have to see us as an extension of their own R and D team, complimentary to what they do, and UM, not all organizations can think that way. You have to be willing to go against the not invented here syndrome. So that sort of puts a little more heft on the name of the firm research affiliates, because essentially you provide intellectual um property and research strength to

the affiliates you work with. I never really thought of it in quite those terms, but really that's what Raffie does. That's exactly right. Was that intentional or did we you just happen to stumble on that? Um, a little bit of both. I was running first Quadrant at the time and had decided if I'm ever going to start my own business, I had to do it sooner rather than later, and so I was running both in parallel for two years. Running both in parallel for two years meant I had

to be studiously avoid conflicts of interest. So initially we started out saying, let's subadvise, let's license our ideas, and we found that that business model works, so we stuck with it. Quite fascinating. Let's talk a little bit about factors investing um Fama French famously identified first the three factor model, then the five factor model, then the seven factor model. Are there still factors out there that have yet to be discovered? Two answers to that question. Firstly, yes,

there will be. They've already been five factors published five and um there will be hundreds more. Now the more pertinent question is how much of this is data mining finding relationships that prevailed in the past that have no reason to prevail in the future, And how much of it is um truly factors that drive price that can be truly a reliable source of access return, Meaning is there enough outperformance here that can be captured by a portfolio? Exactly? So?

Of those five So if these were really good factors, why wouldn't we create a if not a five hundred factor portfolio. Hey, let's put these in order of the strongest out performance generators, and here are the fifty or five best factors. Why can't we do that? Well? I wrote a paper a couple of years ago called how can smart Bay to Go Horribly Wrong? And I remember that it was massively controversial. I thought the controversy was amusing because if I'd written a paper entitled how can

Stockpicking go Horribly Wrong? And I offered the the sage inside that if a stock soars and its fundamentals haven't, so it's valuation multiples have sword, it's past returns will look artificially wonderful, and if there's any mean or version on valuations, it's future performance will, to use a technical term, suck so um. People would have read that paper and said,

what's this nitwit talking about? Everybody knows that by saying exactly the same thing about factors and smart beta strategies, I was pilloried for suggesting that the same thing could apply for strategies. Now, if you go back historically, you find that the alpha of many of the smart beta factors have has not been tested in terms of how much of that access return came from rising valuation multiples. We might as well have a an Apple factor that

simply says Apple has outperformed magnificently. It is a powerful factor. You have a long Apple, short everything else factor, and because of the past performance, we know it's going to continue to work. Let's digress a little bit and and define factors for people who may not be familiar with Gene Fama, who won the Noble Prize a few years ago for his for a lot of his work. UM the original and its Gene Farm in Ken French at

Dartmouth Farm is a Chicago. The original Fama French factor paper was small capitalization value, and I'm trying to remember was that momentum, quality, market market beta market. So that's the three, okay, and then when we moved to five, we added um uh, quality and momentum. That's the next lot, and then seven. I don't even know what the next two are. I'm not certain, but I think it's illiquidity and investment. Right. So, so all of this comes back

to let's let's keep it simple. Low cost stocks over long periods of time, low uh better value stocks, not expensive stocks. I don't mean low price tend to outperform expensive stocks over the long haul, exactly right now. Advocates of efficient markets will say it's got to be because of some kind of hidden risk, because you can't get something for nothing. Um. I would push back against that

and say it's not risk with value. Might be risked with small cap because there and then there's a liquidity issues, but with value, it's the psychology it's the behavior of who wants to buy this. Dominoes is one of my favorite examples. Domino's had a big, a whole run of issues late nineties early two thousands. The stock did poorly. People were thinking, all right, well, that chain is pretty much done. And Dominoes over the past I think it's

either fifteen or twenty years, has handily outperformed Apple. May be getting the timeframe wrong. So and that's the psychology of who wants to touch that? And if you look from the trough in two thousand nine, Uh City ever so briefly dipped below a buck, be of a dipped to roughly two bucks, and since then those have handily outperformed Apple. Um so, but they've outperformed it from a starting point of being thought on death's door. So value,

it seems to me, does have a behavioral basis. Basically, when you have a value orientation, you're buying what's unloved, what people want to shun. That should be rewarded. Now is it a hidden risk factor only psychologically? Well, let me let me push back a little bit over there. Two companies in financial crisis look terrible. One of them's

a I G. The other's Lehman brothers. You can buy a I g rescued and and since pretty decent, not great, but pretty decent returns off of the bottom and Lehman, I guess we could call that a value trap. Although there were elements of fraud and RepA one oh five, there was a whole different set of problems with Lehman. But the risk with value is am I buying something that's going to be a zero? That's known as a value trap. It's a stock that looks cheap on its

way to zero. Now it's hard to have a whole sector that looks cheap on its way to zero. I coined the term anti bubble in two thousand nine to describe what I perceived as the inverse of a bubble, where an entire sector of the economy is priced as if they're all headed for oblivion, when in fact, every failure clears the runway for the survivors to have higher profits,

higher margins, and greater success us ahead. So, unless you wanted to um except the notion of armageddon the end of the economy, uh you, it made sense to think that collectively this sector was being dismissed when it shouldn't be. There's a whole group of people that are the armageddon traders. I think the Ft called them the plastic bears. They'll scream arm again, but then they'll he here's what we can sell you while we're waiting for armagedon um. The

other thing about anti bubble is so fascinating. You could say there's an anti bubble in what was it? Home builders and oh five and mortgage brokers and bankers and oh six and pretty much anything else in finance and O seven and each almost every there's almost always some sort of bubble in the market somewhere and some sort

of anti bubble in the market somewhere. You go back to early two thousand sixteen emerging mark, It's deep value was priced at two to three times cash flow, and it's not as if the emerging economies of the world were collectively all going to go bust, so it represented an extraordinary opportunity. Rafi, the fundamental index in emerging markets was briefly trading for a Schiller Pe ratio below six. Wow,

that's amazing. Let's talk about a study you did way back when looking at the SNP five index, which theoretically is a passive, and we'll put a footnote on exactly what cassive means. In this you found from to the last year there was a full year of data available, stocks added to the index underperformed those that were kicked out by an average of twenty three percentage points over the ensuing twelve months. That's not a bad gap in return.

Oh my goodness, that's amazing. So so what are the occations of this and what does this mean about the stock picking acumen of the editors on the committee of the SMP Index who select the stocks that go into it. I don't fault the index committee for the way they make choices. They they are under. Their clients are the people who license the index, and the people who license the index want the index to include all the names that are hot, beloved, and are embarrassing not to have

in the index. Just added was Twitter as of this tape in okay Um. And if there's a stock that has been brutalized, unloved, dirt cheap and nobody wants it, it's embarrassing to have it in the index. So of course they're going to take those out. Now, what happens is two things. Firstly, they announce a change, and they

announced the date the change will take effect. That gives the index funds a grace period in which to trade where they're going to move those stock prices, and those stocks will still be in the index, so it won't create a performance drag. There. Everybody, please front run our trades. Well, there's a hedge fund community that does exactly that. So the trades are made, the positions built, and then given over to the index funds on the effective date, preferably

at or near the close. The stocks added when you compare them with the discretionary deletions deletions that aren't related to corporate actions, um outperformed by nearly nine percent during that grace period. So when index funds say we don't move stock prices with our trading, that's that's rubbish. Um. They let other people move it on their behalf, and

they could say, oh, look we haven't moved this. Well there's that, and then there's also the simple fact that the ads beat the discretionary deletions by nine during a period of days. Well, that's a big move. So you also have part of that return difference in the subsequent year is simply mean reversion taking the price impact of the index funds back out, and part of it is

quite simply. The stocks added are extravagantly expensive on average, and the stocks dropped are usually a deep discounts um over nine of the ads are companies trading at premium multiples. Over the discretionary deletes are trading at a discount. And the average gap between valuation multiples of the ads and of the deletes is more than three to one. That's amazing. So let me make the case for quote unquote passive indexing. I think smart data. Let me caveat this. Smart data.

Is that the wrong phrase. It should be fundamental indexing. Passive investing is a wrong phrase. It should be low cost indexing. But here's the pro indexing argument, and I want you to take this argument apart. This is the most cost effective, least expensive way to get exposure to equities. It has the lowest amount of turnover, the least amount of tax consequences, and everybody seems to have the greatest difficulty outperforming the SNP five hundred. So we're gonna keep

using that as a benchmark going forward. Discuss the Bill Sharp wrote a piece in the nine nineties entitled the arithmetic of active investing, and it's a very simple thesis. The market is capitalization weighted. The index fund span almost all of the market and is capitalization weighted. You take that portfolio, all of the indexers out, and what's left is what active managers collectively own. Well, it's the same portfolio,

giver take some wiggle room. So if it's the same portfolio, active managers should have the same per formances index funds minus costs, and the costs are higher for active managers. That arithmetic is not just true, it's a truism that means that if you're choosing active managers with absolutely no skill, you should expect to earn index returns minus um when you choose an active manager. This doesn't mean in choosing

active managers as a waste of time. What it does mean is you'd better have a good answer to the question if this active manager is a winner, so there's a loser on the other side of their trades, who's the loser and why are they are willing loser for fundamental index The answer to that is really simple. This is a strategy that contratrades against the market's biggest and most extravagant bets, and so the loser on the other side of the trade is the performance chasing lemmings who

are legion. Here's the Bill Miller pushed back. Most active managers are as you've described, with a very low active share and essentially their closet index ers. So why on earth should anybody pay a high fee when you could pay a low fee and get the same portfolio. Fair fair criticism, It's a fair criticism. There's a lot of active managers hiding the bushes near the benchmark. Most active managers are constantly looking over their shoulder at the benchmark

and worrying about beating it. The beauty of fundamental index and of smart beta as it was originally defined. Smart beta originally meant strategies that break the link with price, that don't pay any attention to market capitalization or a price in setting the weight of a stock. This term

has been stretched to the point of meaninglessness. But um, under that definition, you do have the advantage that you're going to be contratrating against the market's biggest bats um, whether you're equal weighting or fundamental index or minimum variants, you're going to be having an anchor a target weight that isn't related to price, so as the price sores and tumbles, you're gonna be selling and buying. It's built

in structural cell high Bilow discipline. Fascinating. We were talking earlier about traditional passive investing or or low cost indexing. Let's let's do a little bit of a compare and contrast with UM fundamental indexing. And we touched on this. I want to give you a quote from Burton Malchiol. Smart beta strategies are riskier than index funds and not right for individual investors. What is professor Malkiel getting wrong there?

Malkiel comes from the efficient markets community. He believes he wrote random Walk down Wall Street back in I think

the sixties. UM. It's interesting to note that if you believe that UM the the share prices equal a fair value that we cannot see plus or minus and error adding up to the price, And if you believe the market is constantly hunting for those errors and trying to fix them so that the error is mean reverting, then contratrating against big price moves has a structural alpha that is in fact the key driver of the value effect. If you look at value strategies, the alpha comes from

the rebalancing, not from the cheapness of the stocks. Well, isn't that the same thing. When we say a stock is cheap, we're essentially saying it's trading at a discount to its fair value, and once that rebalance o cards it should snap back to that and there are gains. Well, just as an example, fundamental index overweight stocks that are trading at discounts proportional to the magnitude of the discount, underweight stocks trading at disc premiums proportional to the magnitude

of the premium. So your systematically downweighting the growth stocks and upweighting the value stocks. You're saying, thanks for the gains on the growth stocks, let me trim it back to its economic footprint, thank you for the discounts on the value stocks, reweighting it back up. So there's a structural value tilt. Well, why then, does this strategy relentlessly beat cap weighted value indexes Russell value EFA, Value IFA Emerging Markets value UM winning against the value index is

seventy or eighty percent of the time, year by year. Uh. It does so for the simple reason that value indexes are themselves cap weighted so they're going to overweight the overvalue and underweight the undervalued value stocks, even within the universe of value correct um. Think of it this way. If a stock outperforms in the future, then it must have been under under price today. If it underperforms in

the future, it must have been overpriced today. And what stocks get the most weight in a cap weighted portfolio those that are overpriced. So let's let's address that. Casette raises a really interesting question. When we look at cap weighted indexes, we end up owning more of the names that are outperforming have been out, I've been out before, and since we know momentum as a factor, the assumption is that those outperformers will, at least for some finite

period in the future, continue to outperform. So we end up owning more of the winners that are keeping winning and less of the losers that are keeping losing. Or so goes the cap weighted indet argument. What's wrong with that claim? Don't we want more exposure to stocks that

are winning. Here's what's fascinating. Yeah, momentum is a powerful factor across multiple asset classes spanning decades, but within stocks, momentum was first published by professors jagged Yaian Titman back in nineteen two or three, and since nineteen momentum is a strategy in the stock market hasn't worked well, hasn't worked, it's underperformed some other factors. No high performing stocks have

underperformed low performing stocks on average since ninety nine. So is that due to the dot com crash in the Great Financial Crisis? How is it operated? And I know you can't say I only want to invest when we're not in a bubble or in a crisis, but how significant were those events to the underperformance of outperformed tremendously significant.

And you put your finger on it that when you have a strategy that outperforms for a while, then crashes, outperforms for a while, then crashes net net, it can look terrible if you can use it only when it's gonna work. Great an index that does that exactly well. In point of fact, when um, when momentum is telling you the extravagantly priced growth stocks are the ones with momentum, That's when it's more likely to have a crash than at other times. When momentum is saying the value stocks

have turned and are showing positive momentum. That's when momentum historically works best. So the combination of the two value and momentum tends to be a really nice combination. But be very careful about using momentum when it's telling you to chase bubble stocks. If you can switch it off, do so. Let's talk about the combination of value and momentum. Uh. West Gray of Alpha architect wrote a piece Who's Who's um?

Title I love about combining value and momentum, which essentially says even God would get fired as an active manager. And he said he suggests that while we know the combination of value and momentum outperforms just about any other combination can come up with, there are these occasional draw

downs that can be brutal. Absolutely so, So how do we explain why value and momentum outperforms just about any other combination of factors if we still get these really horrific periods of time where gee, this doesn't seem to be working. Well, simple fact is, no strategy is going to work all the time. UH. Contraining investing is arguably the most powerful and reliable UH long term form of investing. Basically, whatever is newly cheap is going to have performed terribly.

It will have inflicted pain and losses. People don't want more of that. Imagine an investor saying, oh, I just lost a ton of money on this, give me more of that. Uh, that's what a contraining investor does. Um a strategy that's provided great joy and profit, a stock that's provided great joy and profit. How many people look at that and say, oh, get me out of here.

That's what a contraining investor does. And so with contraining investing, you're going against the crowd that's profoundly uncomfortable, and whenever it fails, whenever it doesn't add value because the expensive popular stocks are getting more expensive and the cheap garbage stocks are getting more cheap. Anytime it does fail, people start to think you're an absolute idiot. So let's talk

about that for a second. Because my office has a value tilt, as does everything that the research affiliate or many. I shouldn't say everything, but many, everything just just about. And yet we're in a period where we have the fang stocks, we have these tech companies doing great, and value is going through one of its periodic stretches of under performance where people stop and say, I understand the concept behind value, but look at Netflix, why why do

we want to own these cheap stocks? The expensive stocks are doing great. So two part question, A, why do we go through these periodic spasms of of significant underperformance? And B is that what enables value to over the

long haul outperform growth. Let me answer be first, Yes, that's exactly why it outperforms in the long run, because it's uncomfortable, but the periods, and because when it goes through a period of disappointment, is very easy for people to abandon a strategy that's on comfortable the making the cheap stocks that have become cheaper even cheaper still correct. So it is really important. When we wrote the paper

how can smart be to go horribly wrong? We showed that when a strategy becomes more expensive, it creates a a surge in relative performance, making the strategy look unusually powerful, while so sewing seeds for future disappointment because the strategy is newly expensive. The same thing applies to value. Value

in two thousand was profoundly cheap. The gap between growth stocks and value stocks was eight to one in valuation terms um By two thousand and seven it was two and a half to one too, and after one sounds like a big gap, it's not. It's considerably narrower than you usual. And so in two thousand seven, objectively value was priced high relative to its own history, and that's what set the stage for the quant crash in August of two thousand seven. That was a very crowded trade

a lot of people had. But that you know, you, you you reference quants. That makes me think of a quote of yours which I don't believe is still true. Or maybe you could disabuse me of that notion. You once wrote, our industry hates arithmetic. Now that was certainly true decades ago, given the amount of things, amount of assets managed by quantitative strategies, and just the flood of smart quant analysts coming into the industry, does finance still

hate arithmetic? Oh my goodness, yes, it doesn't hate mathematics. The notion of quantitative methods probably almost more popular than ever before. Only two thousand seven might even come close. But the notion of simple arithmetic, the arithmetic of returns is you earn a yield, you have a growth in income, and you have changes in valuation multiples. If you know

those three numbers, you know your rate of return. Disaggregating historical returns into those three components gives you a very clear picture of where returns came from, and looking ahead, you know what the yield is. You know that historical growth is probably not a bad predictor for future growth, which leaves you valuation change. If valuations are high, you're more likely to have mean reversion down. If valuations are low, you're more likely to have mean reversion up. So when

markets are expensive, you have a lousy yield. Growth is what it is, and valuations are more likely to come down than rise, and when markets are cheap, the opposite holds true. So that's the arithmetic people hate. When we're in the tenth year of a bull market, tenth year of an economic expansion, when times are good and people have had wonderful success, their expectations for future returns go up,

not down. Now, that's interesting because when markets are rising and yields are falling, your forward looking return is eroding. You expect the return should be lower when things are pricing and higher when they're cheating, right, and people think the opposite way. Um, it's interesting. At the market lows in eight seven in two thousand two, uh, and again

in two thousand nine. Each of those three episodes, I found myself on a plane next to somebody who was saying, I'm never gonna be investing in the stock market again. Are all three time? So that's fascinating. Can you stick around? I have a ton more questions for you. We have been speaking with Rob are Not. He is the founder

and chairman of Research Affiliates. If you enjoy this conversation, be sure and check out our podcast extras when we keep the tape rolling and continue discussing all things smart Beta. You can find that wherever final podcasts are sold. We love your comments, feedback and suggestions right to us at m IB podcast at Bloomberg dot net. Check out my daily column on Bloomberg dot com. Follow me on Twitter at Ridholts. I'm Barry Ridhults. You're listening to Masters in

Business on Bloomberg Radio. Welcome to the podcast, Rob, Thank you so much for doing this. You we were discussing earlier. You were one of the original old people. We kinda first tested the water with the podcast with series back in I want to say, right, that's that's when we launched it, and you're you're one of the people where a couple of years later, I kind of said I wanted to ask him about this. I didn't even bring

up that I forgot this. I forgot that. I gotta bring him back and go over some of these things. So thank you so much for for returning. I'm fond of saying this is the most fun I have all week. So uh, this is uh yeah, right, I have to sit down with people like you and Danny Kanaman and Ray Dally and Howard Marks. That is my cross to bit and hopefully yes, so it's an ugly dirty job,

but somebody's got to do it. Let's um, there's a ton of stuff I didn't get to And since we were talking about expensive stocks and tech stocks, let's talk a little bit about fang Uh we see the fang stocks that have you know, just taken off over the past five or so years. But there's also let's do a compare and contrast with the es. These are real businesses with actual revenues some of them and profits well, Apple, Amazon, uh, Netflix, Google, go down the top ten tech stocks. It's not like

the ephemeral or is it. Let me ask you the question as opposed to answering what are the parallels between today and the sort of mania we saw in the nines? Are there parallels? There? Sure are? UM. I wrote a paper recently entitled Yes, It's a bubble? So what? Okay, that's one of my questions. Let's let's go over that because I love the title. Yeah, the point of the

paper is twofold. Um. One point that we make is that the term is bandied about without a definition, a bubble, bubble, and so we make an effort to give a um an objective definition that people can actually use as a test for saying, is this a bubble? And that objective definition is one where simple measures of fundamental business success you have to make um exceptionally aggressive assumptions to justify the price of a stock, or a sector or a country.

So you don't like the Potter Stewart definition, I know it when I see it. It's a little vague, a little vague. And the second part of the definition is that the marginal buyer is somebody who is not buying because of a careful analysis of fair value, but is buying because they expect to be able to resell to somebody else at a higher price. Greater fool theory correct. So you look at the fangs today, the marginal buyer in most cases is not somebody who's done careful analysis

of forward looking expected rates of return. The other parallel with the tech bubble is that at the peak of the tech bubble, five of the eight largest market cap companies on the planet. We're tech companies today seven of the eight largest our tech companies. The valuations aren't as extravagant as they were in two thousand, but the concentration at the top of the list in global market cap is even more. So let me push back on that because we've we've been debating this um with some folks

in the office. So technology today represents the elimination of human ingenuity and effort. And why wouldn't technology companies that don't require a giant infrastructure. Think back to the railroads. It costs inflation adjusted billions to lay thousands of miles of tracks and all the manpower you had to hire in locomotives and rail cars and all that stuff. Right,

Completely tapping intensive, completely labor intensive. Now a startup is a couple of guys on a laptop and an internet connection, so you don't have the same capital requirements you don't have the same labor intensity and the ability to scale is immense. So shouldn't the A shouldn't these companies be trading at a premium? And B shouldn't they be dominating the market? Courts? Hey, this is the future and technology is driving us all with robots and driverless cars and

automation and your name it. But you tell me which companies are going to be the center of innovation ten years from now, and I will happily acknowledge that those companies deserve massive valuations today, huge multiples. The problem with that thesis is really simple, and that's casting a BroadNet. You're going to have a lot of companies with a fantastic story. Back in two thousands, this story was these

companies are changing. It's a new paradigm. These companies are changing the way we do business, the way we communicate. They're radically reshaping the macro economy, and this industry is going to be changing our world. So of course they deserve massive premium multiples. What was overlooked was that these companies were disruptors, and the disruptors themselves get disrupted, often

very fast. So how many search engines preceded Google how many how many handheld devices preceded the iPhone, and we're seen as utterly dominant. BlackBerry own that market for the palm. Palm briefly was trading for market cap greater than General Motors and and both of them eventually went to zero. So you have an industry with massive change. Here's a

fascinating thing. The ten largest market cap companies in technology in the US in the year two thousand, um how many of those outperformed in the eighteen years before a start of two thousand and the start of this year. Zero a single one, not one beat the market. The fascinating part about tell me the companies ten years hence, look back ten years ago. There was no go down the list. Facebook was in public, Twitter was in public. Netflix wasn't public. Actually Netflix was public, but they were

sending DVDs through the MAIP. Go down the whole list and go to ten years previous to that. Google wasn't public. You could, you could. Apple was thought to be going bankrupt. Amazon was a glimmer and Jeff Bezos is I So it's ten years doesn't seem like a long time, but making a forecast ten years, hence, it's all but impossible. You could get lucky. But here's another fascinating thing about

um bubbles and about markets in general. If you take the ten largest market cap companies on the planet, on average, only two of them are still on that list ten years later. That's amazing. It's eight or under performers. Now, the eight that fall off the list are obviously and assuredly performing worse than the eight that replaced them, and the eight that are on definition by definition, and the eight that are on the list today have a bigger weight than the ones that replace them. So you have

this drag associated with capitalization waiting. So even the top ten reinforces the notion of what's wrong with indexing. That doesn't make it easier for active managers to add value if they're looking over the shoulder and wondering, how am I hurting myself by not owning Netflix? Or shouldn't I

really take advantage of the dip and buy more Tesla? Now, I just we're recording this on a day when the Wall Street Journal had a column out, I'm sorry it was Bloomberg had a column out that said Apple a stone's throw away from a trillion dollars and the biggest market cap company is actually trading in a much lower multiple than the previous times, when, at least on an inflation adjusted basis, we had companies approaching the same level.

Apple at eighteen times is much cheaper than go down the list when it was Qualcom, when it was Microsoft, when it was whoever. Uh, so are the faning the problem? I guess we run into Apple. A new favorite of Warren Buffett's is cheap Amazon, now that they're starting to show a profit by any rational measure other than pure growth and market share, looks very expensive, so as does we Work, and a bunch of others. Well, the private company's uber we Works. Yeah, tharaos that one didn't work

out too well. But go down the list of the so called unicorns, what does that tell us about how much capital is chasing? Exactly right? And when you're talking about the unicorns, the very simple fact is some of them are worth every penny of what their valuation is today. I just don't know which one. And uh, if you can pick those um Google since it's i p OH has been a persistent favorite for value managers to underweight it and for value manager for deep value managers to

even short it. Okay, well that's not working out so well. But for every Google, there's a palm Um, there's Uh, there's an array of companies where you look back and say, as you did with Saraos that didn't work out so well. Thin Nos was hot, it was going to change the world, right, But that was an outright fraud. That's very different. And and Elizabeth Holmes, the founder and CEO, just settled fraud accusations from the s with the sec The company is

laid off almost all of its staff. Heartily recommend Carrie Row's book Bad Blood. It's a fascinating read. Uh. And we'll get to books in a minute. But where there aren't cases of outright where it isn't a scam, where it's which a legitimate company who, for whatever reason, its moment may have passed. How can you determine with any degree of confidence this is a company that's going to be around for ten or twenty years. You can't. You

can't um x andity. You can't say which of the popular, beloved star companies are going to be around in ten years, let alone which ones are going to outperform. If history is an example, Uh, there were tech companies that were uh uh described as being sensibly priced in two thousand

because they were only twenty times the two year forward earnings. Well, look at Microsoft, which has since under the new CEO, Saudia Nadela, has since returned to very quietly, has become the third largest or third most profitable company in the world, third largest market cap. I don't know if that's in tech stocks or stocks in general, and that's something that kind of was left for dead after the dot coms, so no one would have very few people were predicting

Microsoft was going to make a comeback. I'm surprised Buffett, with his friendship with Gates, didn't recognize the value and Microsoft UM. But the question that all this comes to is if history tells us that these top ten stocks, most of them are going to drop out of the top ten, is its simple valuation mean reversion or is something else at work here? Part of it is valuation

mean reversion. Part of it. We wrote a piece UM called too Big to Succeed, kind of a play on the notion of too big to fail, and the point of that paper was the largest market cap companies get there because they're big, successful businesses and trading at high multiples. You don't get to the top of a sector or top of the market without both conditions generally being true. For that reason, UH, these companies are likely to disappoint

just on evaluation basis. Now, add on top of that the fact that now these companies are so visible that everyone's taking shots at them. Their competitors are after them, regulators want to put a new notch on their gun barrel. Uh. The list goes on and on, and so Apple goes from being a beloved trendy darling to being under attack from regulators all over the world, UH, questioned and challenged because of the buggy nous of some of their um uh software these days. Look at General Electric is a

perfect example. They're a greater love darling than g in the in the nineties, not at all, And I, best of my recollection, it has not outperformed since then by much it's gotten. So I have to ask you. You keep referencing various white papers, um how smart batic could go disastfully wrong, too big to succeed. There was one other you mentioned When you and the research staff at Research Affiliates are thinking about writing a white paper putting

it together, who is your target audience for that? Are you writing that? You know? Daniel Borstein very famously said, I write to figure out what I think. I'm going to suggest that's not the motivation with your white papers. You guys already know what you think. Who is the target audience for those papers? You know it's a really

good question, because there's not a really good answer. Yeah, we'd love for our papers to be accessible to the ordinary Joe on the street, mom and pop. Investors aren't really reading white papers. That they aren't reading them, and the papers are in many cases too subtle, to mathematical, too complicated. When I get to page seven and it's all formulas, that's where it's happened. Well, we don't do that. We don't do formulas the way I finance general would,

but we do. I think our general target would be somebody with the sophistication of the average financial advisor. If we're writing over the heads of the average financial advisor, we're not doing anybody any good. If we're writing below that level, we run a risk of oversimplifying. And uh, we do love challenging conventional wisdom. I've made a career out of looking at things that are generally perceived to be true and testing them, and sometimes they are true

and sometimes they're not. And when they're not, you get a paper out of it that rattle some cages and that maybe even can change the business in a modest way. So um, one of the things that I've found is that when you write a paper that challenges conventional wisdom, there's somebody out there. In fact, usually there's lots of people out there who have made a career on that conventional wisdom. And boy are they angry to say to

say the least. So one of the questions that keeps coming up on the just low cost indexing side is, given the growth of Vanguard and black Rock four trillion and five trillion respectively, I think they're gonna be five and six in a short period of time. The question that always comes up with low cost passive indexes is hey, how big can these get before it no longer works?

I look at smart Beta, from it tripled to over six billion, it's a stone throw Uh now from a trillion, it's almost as big as Apple, almost as biggest Apple, almost as big as one stock. At what point? So there's well, the biggest stock, But at what point does this top out When does it become so large that everybody's doing it and therefore there's no outperformance in it. Firstly, smart beta has been to become a catch all phrase that spans a lot of strategies, many of which aren't

smart at all. So the notion that it's just a label, right, So let's stick forget smart beta. I don't like passive indexing. I don't like smart beta. Let's stick with fundamental indexing, and we'll stick with price to sales, price to earnings, price to book value, price to dividend, which I think is a fundamentals where where research affiliates began. And that's did we say that's or more of the indices you create? Um, it's it's about UM eight of our A U M.

The rest is global asset allocation strategies. Now, in terms of capacity, different so called smart beta strategies have different capacity. Some of them are very high turnover UM, heavily involved in illiquid companies, for instance, um UH. Roger Robbertson's favorite strategy is an aliquidity strategy. You're gonna focus on companies

with low liquidity. If you're trying to run a hundred billion using that forget not even a chance that, but that works for a small niche funds, and that's absolutely now fundamental index still to this day pretty much unique among the so called smart beta strategies, does have vast capacity. Why you're spanning the broad macro economy, you're owning pretty much everything you're trading consists of contratrading against the market's

most extreme bets. So when a price is soaring, you're trimming, well, it's easy to find a counterparty to those trades. If a stock is tumbling, you're buying. It's easy to find a counter party of those trades. You're you're trading is spread across a thousand and companies instead of concentrated as with SMPI indexation in whatever stocks are being added or

deleted that particular week. So let me channel Jack Bogel and say, all that makes perfect sense, But all that trading is expensive, and the gains are offset by your turnover and your trading costs. We're selling what people want to buy, We're buying what people want to sell. So are trading costs at this stage have been immeasurably small. At some stage, at some size, we start to move prices we're not there yet. How did eighty billion and

we're not there yet? You know, there's a ways to go before you have to really be concerned about that. The trading costs for classic capuated indexing are much more vivid, much more substantial, measurably so because during that grace period you get a nine percent spread between additions and discretionary deleting. But that's not the trading costs. That's the actual na V gain or loss from the trade. They what do they do? They lose half a dozen stocks, they had

half a dozen stocks. They do that once a year. Their trading costs accord. He does it multiple times a year, one or two or three stocks, when there's mergers, when there's takeouts, when there's things like that. But when I look at something like a price to to earnings ratio, when you're buying things fundamentally ranked by earnings that changes quarterly, how often do you have to rebalance that that index?

There's two flavors of fundamental index. The original Footsie RAFFI rebalances once a year and has ten to annual turnover. That's all. And that ten to fifteen percent is spread across a thousand companies. It's not concentrated in a dozen additions or deletions. The um. Other flavors of Fundamental Index, our own Raffi series and the Russell Fundamental Index are use what we call quarterly staggered rebalancing, which means every quarter you move one fourth of the way to the target.

Makes sense, you're letting it out. You let momentum run on three fourths of the portfolio, and one four of the portfolio. You say, okay, enough momentum, we're going to rebalance. And by doing it that way, you have the same turnover as once a year rebalancing. Still ten to fifteen percent annual turnover. It's very low. It's very easy to trade. So I don't I don't fret about implementation costs, trading costs, moving market prices until we're in the trillion dollar range.

So we've talked about Van Goard as a competitor in black Rock. Let's let's let me bring up something just because I'm looking black Rocks. So one of our licensees they run over ten, so they're an affiliate, not really a true competitor. Yeah, they have competing product and they have uh licensed product they're running over ten billion globally and RAFFI strategies, so you're you're happy with them, Um,

I'm looking at price to sales, price to book. Let's talk about Dimensional Funds, which is about six billion, and their core fundamental index is similar to yours, and that they look at price to book and other FAMA based FAMA French based factors. But really that's the core of of what they do. How do you look at them relative to to research affiliates and what what you guys do well. RAFFIE in US international and emerging markets has has um pretty reliably trounced the d f A value

products and for an extremely simple reason. D f A hues to the religion of efficient markets and says we're gonna we're gonna anchor on cap waiting for I mean, within their price to book, it'll be get they're gonna cap you know, I'm gonna get pushed back and they're gonna say here's wrong. I'm gonna forward you that email and you can look forward to the email. But in any event, they anchor on cap waiting, which is which

is a mistake, and they do wonderful work. I don't want to be seen as suggesting that that they're doing something bad. They're doing something better than conventional cap weighted indexing, but they anchor on cap waiting. That's that's their starting point, so and that's their mistake. I'm gonna have to follow up with that. So I only have you for another ten or fifteen minutes. I have dozens more questions. We'll

have to have you back for another time. But let me jump into some of my favorite questions that we ask everybody, and I'm looking forward to hearing your answers. Tell us the most important thing that people don't know about you. A lot of people see me as a very serious UM research guy. Uh. In point of fact, life is short. Having fun is absolutely crucial, and I know that about you from camp Ko talk. And so I don't do anything. I don't do any research. I

really don't do anything that isn't fun. I like that answer. I'm going to skip ahead to my question number eight. What do you do for fun outside of work? Well, I collect vintage motorcycles, fastest of their era. I like good wine, and I'm a movie junkie. I I have watched UM. I write down the movies that I watch and I rate them on a five star scale. And I've watched over movies in the last six years. Wow, that's a lot of movies. Do you modern stuff, classic movies?

What what's your favorite job? I don't have a favorite. I don't watch a lot of the really old movies, old as in twenties and thirties and forties, fifties. I just saw Roman Holiday the other day. Oh, that's a wonderful film. She's just delightful. Yeah, she was taken from us much too young. But in any event, the the uh, I like variety in films. Uh, that's grace who was taken too young. I think Audrey Hepburn lived a fairly long she was doing Katherine Hepburn lived a long time.

Audrey Hepburn I think died in her late sixties. You could be right. I am just let's google that. Actually this comes up as bing, which I don't know why. Uh, sixty three, you are correct, very good memory. Yeah, yeah, she had a cerebral hemorrhage while walking down the street in Manhattan, just suddenly dropped. Really sad. But in any event, very eclectic tastes in films, if it's mainstream Hollywood actable. I'm bored. If it is weird and strange, I love it,

have you? Uh? I was a giant fan of the original Blade Runner. Did you see the sequel? So the sequel, and then I went back to watch the original for a second time after the original is still an astounding piece of it is I I saw the new one in the theater and I walked out a tad disappointed. But that was almost inevitable, and I'm waiting a full year to see it again with a little more open minded.

Sequels are always done on the basis of an original film that was brilliant, that was extraordinary, and so it suffers by comparison. Patty Shack too, I did not see that. Neither did I. But the assumption is um. So let's talk about mentors. Who do you look at, who mentored you earlier in your career, and who influenced your approach to investment. Um. Early mentors were mostly people I worked for who were brilliant. Dick Crowle at the Boston Company, UM,

Bob Lovell at Crumb and Forster at First Quadrant. He founded First Quadrant and brought me in his uh president and then as CEO later and um um those would be two of my most influential mentors. People I didn't work for who were mentors. Peter Bernstein was massively influential god and the way I think, oh he was he was such a mench He was against the against the gods. Well, here here's the here's the pitch story. I want you

to publish my book. It's going to be a book on the history of probability theory in finance, and it's going to be a best seller. What And it was the best seller. It's sold to famillion copies. Such an amazing book. I'm slowly working my way through the rest of his uh, the rest of his work. And he influenced you from afar. Did you have talk with him or meet? Oh? We became very good friends, very good friends.

We worked on two journal articles together, one for Harvard Business Review and one for Financial Analyst Journal, which were two of my favorite papers that I've been involved in, partly because he's such an effortless writer. The paper for the Harvard Business Review, he said, why don't you do

the first draft? I did, and he called me after he received it and he said, Rob, there's some gems in here, but this is a turgid mess and right blunt a little a little blunt, but in a nice way, in a in a hey, let me polish this up a little bit. Yeah, let me do a complete, massive rewrite and turn it into something that the average businessman without any investment savvy to understand. And how did the paper come out? Came out in the Harvard Business Review?

I mean, I mean what was what was your final read of it? Did you like what he did? And how could you not? How could I not? Um? The paper was titled by Harvard Business Review. We didn't come up with the title The Right Way to Manage your Pension. Uh. That's a little arrogant. But it's attention grabbing. It's attention grabbing. Uh. And it was. It was an influential paper. So since we're talking about Peter Burnestein, let's talk about your favorite books.

What are some of the favorite things that you have read? And I'm just gonna assume iron rand and move beyond that. What I really like you did touch on politics, which is another of my passions. The uh, for those um who don't know me, I'm a libertarian. I believe in limited government, which too few people do. The well there are people who claim to be libertarians, but really they're libertarians for a specific issue, and then they want the

government intervening elsewhere wherever it's convenient for them. That's human nature. The the UH in investments against the gods would be tough to beat. It's fantastic. Anything by Ben Graham is a must read intelligent investor. Yeah, um, security and security analysis. You want to dive in deep um. These are some of the giants of our industry. Um. Outside of investing, and actually most of my reading when I'm not working is outside of investing. A couple of really fun books.

Four Really, there was a year after Columbus sailed for the New There was a book called fourteen nine one that examined the America's before Aumbus landed, and the population of the America's back then was probably in the in the couple of hundred million range. Really, I would not have guessed that massively wiped out by measles and other diseases where they had no no built up, no genetic ability to fight those diseases, so wiped out a hundred

million plus people. Native Americans were here before Columbus landed. I would earlier arrivers. Earlier arrivers said that the shores were teeming with people. Fascinating. Uh was the sequel to that book, and I think it was even better. It shows how global commerce has reshaped the world and how

it creates seeds of tremendous risk. Another book that I've been enjoying immensely, partly because it's so you can pick up, pick it up, read a page or two, and then put it down and come back to it a month later and you haven't missed a beat. It's Letters of Note, which is filled with letters written from person AID to person B going back three thousand years to modern times.

Letters that are just fascinating. A letter from a woman in China to her husband headed off to war UM written four b C and the passion in her worrying about him, wanting him to be spectacular in battle, but please come home, and uh, you know, it just reminds you that all of these people were human beings. Even a letter from um Jack the ripper to the police taunting them, and you feel the evil humanity in the letter. It's just fascinating. I'm gonna definitely check that out. That

that is quite impressive. Tell us about a time you failed and what you learned from the experience. Well, I was invited to be a global equity strategist at Solomon Brothers in nineteen eighty seven. UM. I lasted there for fourteen months. UM it was a wonderful learning experience. UM I naively, I was only thirty two at the time, and I naively thought I was coming into be global equity strategist, But in fact I was coming into UM

reinforced sales. Of course, of course that's the job. And I remember I was brought into a T T S pension fund um UH the week after the market crash. They were using a mean variance optimizer mark What's optimizer to look at their asset allocation, and they were puzzled. They said, we did an optimization. We pushed up return expectations for stocks, pushed down return expectations for bonds because the yields tumbled, pushed up the risk assumption for everything.

By it seemed like a very reasonable, even conservative approach. And our optimizer is telling us to get out of stocks and put it all in bonds, and we're it's setting wrong with that, optimizes. So I came in and I explained the mathematics of why the optimizer would do that and ackwards looking as it is. No, it was forward looking. It was forward looking. They were assuming higher the inputs coming from which is now happens on misremembering this,

Their inputs were forward looking. So they pushed up the return for stocks because they'd crashed, down the return for bonds because the yields had crashed, and it still wanted them, and it still wanted to put more into bonds because they pushed the risk up for everything. Now I went through with them the mathematics of why it was saying that, and then I concluded by saying, throw out the optimizer

by stocks. Well, oh my goodness. The reaction at Solomon in response to that was fascinating because they were salivating over the possibility of a ten billion dollar bond portfolio construction exercise that would make them uh thirty forty basis points on on ten billion an instant fifty million dollars. And here comes this strategist telling the client to do the opposite. Um. Uh, they weren't. They were livid. And the lesson. The lesson learned was you've got to know

who your client is. You've got to know what they want, and you've got to know whether what they want is what you're comfortable delivering. And and our final question, tell us something you know about investing today that you wish you knew thirty plus years ago, oh even fifteen years ago. When we launched fundamental Index. We published the paper and immediately set about saying, if you can build an enhanced index relative to cap weight, you can build an enhanced

index relative to fundamental index. Who better to do that than us? Well, why don't we figure out which of the fundamental measures works best and have the mix of fundamental metrics be dynamic. And what I didn't realize at the time, we failed miserably. Everything we tried didn't work. Um what I didn't realize at the time was when a strategy becomes massively more expensive, it'll have wonderful past

returns and terrible future returns. So we were zeroing in on the fundamental metrics that the market was loving more and was poised to disappoint. So the enhancements failed. Today, I have a better understanding that valuation matters for factors and strategies just as much as it does for stocks. Quite fascinating, we have been speaking with Rob are not

of research affiliates. If you enjoy this conversation, be showing look up an inch or down an inch on Apple iTunes, Bloomberg dot com, Stitcher, overcast, wherever finer podcasts are sold, and you can see any of the other two hundred plus such conversations we've had. We love your comments, feedback and suggestions right to us at m IB podcast at Bloomberg dot net. I would be remiss if I did not thank the crack staff that helps me put together

this conversation each week. Medina Parwanner is our producer, Slash audio engineer, Taylor Riggs is our booker. Michael bat Nick is our head of research. I'm Barry Hults. You've been listening to Masters in Business on Bloomberg Radio.