Index Investing King Rob Arnott Comes to Morningstar ETF Invest

At many advisor conferences, no sooner has the speaker put down his or her PowerPoint slide changer than the hands go up in the audience. After Rob Arnott’s presentation on Friday morning at the annual Morningstar ETF Invest conference in Chicago, there were moments of silence when he finished his prepared speech. It wasn’t an uncomfortable or confused silence. Rather, the audience was still trying to catch its intellectual breath following a speech that was by turns amusing and data-heavy but mostly thought provoking.

Arnott’s theme was smart beta, a popular theme at this conference and among advisors in general. He defined smart beta as living between the active investing and the passive investing approaches, and argued that in addition to making “the ETF and index arena much more interesting,” he sought to answer the question of why smart beta produces better return than active management.

Part of the answer comes from active managers’ need to include popular asset classes and individual holdings in a portfolio, but part of it comes as well from smart beta’s ability to “capture structural alpha.” ETFs, Arnott said, are a “natural vehicle to deliver smart beta,” especially those funds based on non-cap-weighted indexes.

To see whether smart beta actually works, Arnott and his team at Research Affiliates decided to test how five popular smart beta strategies would have performed from 1964 to 2012. While a cap-weighted strategy would have produced a 9.7% return over that period, each of the smart beta strategies added at least 2% more to the return numbers.

To test further whether fundamental indexing outperformed cap-weighting, his researchers decided to “flip the strategies on their heads,” reversing the weight of all the holdings in the fundamental strategies, giving the highest weighting to the holdings that were the lowest and vice versa, and the outperformance held. His conclusion: smart beat outperforms because it breaks the link between price and weighting in the portfolio.

Arnott said that when he had passed along a draft of his findings for comments before going public, one reader asked if his firm could license the upside-down strategy from Research Affiliates. “No, you can’t license it,” Arnott said he replied, “but you can have it.”

Once the audience began to ask questions, one further benefit of fundamental indexing in both the ETF and mutual fund space became clear. A listener — likely an advisor — asked whether Research Affiliates had done any work on the tax efficiency of smart beta.

Arnott answered that in the six years that Schwab had been running a RAFI-based (Research Affiliates Fundamental Indexing) mutual fund that there had been no capital gains distributions, to his knowledge. The same held true for the PowerShares RAFI ETFs, he said.

As for future research efforts, Arnott suggested that long-horizon mean reversion is “the most understudied topic in the capital markets” perhaps party because for investors, waiting for a reversion to the mean can be painful.

He then closed with an appropriate quote from Baron Rothschild, who made his fortune during the Napoleonic Wars. “Everyone knows the first part of the quote,” Arnott said, “’Buy when there’s blood in the streets,’ but few know the second part of the quote: ‘even if the blood is your own.’”

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