A lot of ink has been spilled on smart beta, the purportedly improved version of the beta an investor gets from investing in passive index funds, which are typically weighted by market capitalization.
So in making the trek down to Rob Arnott’s Research Affiliates headquarters in Newport Beach, Calif., I am hoping that a personal interview might lend that extra measure of insight.
And right at the get-go, my first big break comes as my eyes fall on a display case in the reception area housing an original two-volume first edition of Adam Smith’s 1776 classic work The Wealth of Nations.
One of the 238-year-old volumes is open to the page in which Smith states “the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry.”
I ask Arnott about this, and the self-described libertarian displays an impressive fluency in Smith’s thought and its application to current policy issues.
He decries the narrow way the U.S. assesses its own annual revenue — through gross domestic product:
“GDP measures spending, not prosperity,” he says, lamenting an excess of governmental spending on top of borrowing, and like behavior on the part of ordinary people using the equity in their homes as ATMs.
“The smell of that new car is nice — until it’s repossessed,” he acerbically jokes.
The confusion of consumption for prosperity that Arnott sees prevailing today means that we are encouraging spending rather than investing.
“It’s not possible to get a BA in economics without reading Keynes,” he bemoans. “It’s entirely possible to get a Ph.D in economics without cracking open Adam Smith.”
Echoing Smith (how many people nowadays use words like “betterment”?), he passionately sums up the matter:
“This is all to say I have a deep skepticism of the policy elite to make better decisions than the collective wisdom of the millions acting in their self-interest to seek their own betterment.”
As our interview went on, it became increasingly apparent that that same deep skepticism of elites may be precisely the basis of smart beta. By seeking a path apart from the dominant cap-weighted approach, Arnott is essentially expressing skepticism of market elites.
That became clear in his response to the criticism that smart beta is really a form of active investing.
While to some Boglehead types, any hint of active investing is seen as a source of shame, Research Affiliates does not eschew the term — the firm’s website proudly proclaims that its approach combines the best of both worlds.
But in our talk, while acknowledging that he has strong views at any time on what would make better and worse investment choices, he completely reframed who is guilty, as it were, of making active market bets — fingering elite investors and even dumb-beta passive index funds that go along for the ride.
“Relative to the economy, it is the market that is making the active bets. The market makes constant big active bets in the direction of growth, popularity and comfort, none of which should carry incremental rewards. It’s called a ‘risk premium,’ but none of those feel risky,” he says.
He adds, with conviction, that “from the perspective of the macroeconomy, fundamental indexing is the real passive strategy.”
So, ironically, it’s the active, market-aware “contra-trading” that gives Research Affiliates’ beta strategy its smarts and which, according to this view, makes ordinary index funds dumb.
“Do you want to invest in cap-weighted, where the investment is tilted toward the most popular, most beloved, most expensive stocks or do you want to invest in the broad economy, including expensive and cheap stocks in proportion to their economic footprint — and add value by contra-trading the market’s most extravagant bets?” Arnott asks.
Defending his brand of fundamental indexes, Arnott adds: