Smart beta proponents like Rob Arnott oppose dumb beta — that is, unguided market-cap-based indexes — because they believe such indexes overweight the most popular stocks and thus fail to capture the value of unloved stocks whose value has yet to be unlocked.
As Arnott once put it in an interview: “Relative to the economy, it is the market that is making … constant big active bets in the direction of growth, popularity and comfort….It’s called a ‘risk premium,’ but none of those feel risky.”
In contrast, the Research Affiliates founder says of his brand of smart beta — indexes constructed according to value-based, or fundamental, criteria:
“If the market hates a company, fundamental indexing will say: Its value is not showing up in prices yet; we’re going to top up.”
In that spirit, two of Arnott’s lieutenants — Research Affiliates chief investment officer Chris Brightman and head of equity research Vitali Kalesnik — have found an investment opportunity on a potentially grand scale: not a company that the “market hates” but a country whose popularity has been on the wane.
In the firm’s January newsletter, Brightman and Kalesnik devote nearly all of their analytical attention to the risks Russia currently represents before getting to the flip side — the opportunity commensurate with that risk.
Sure, the ruble is cheap, interest rates are high and dividend yields are currently the world’s highest. But investors are steering clear of Russia because of its immense perceived political, economic and default risks, which the country’s actions in neighboring countries have magnified over the past nine months.
The catalogue of woe intensified last month when the ruble fell by 32% and the stock market by 22%, losses that have been largely recovered. Or perhaps the slump in oil prices for more than half a year is the source of worry.
Brightman and Kalesnik organize their risk assessment by looking at three sources of risk, beginning in the political sphere.
Russia’s foreign policy, they say, derives from its constant sense of threat.
“Reflecting the fear that other powers plan to dismember the country, Russian foreign policy is oriented toward promoting puppet regimes in bordering countries,” they write, adding that some of the country’s friendly bordering dictators have strong criminal tendencies. Because the populations of these border dictators eventually get fed up with their Moscow-imposed kleptocrat rulers, the broader region is characterized by general instability.
The Research Affiliates duo note that Russia itself is effectively a one-party state with a subservient media and legal system as well as a state-dominated corporate sector where political considerations might outweigh shareholder concerns.
Ready to write off Russia? Wait, it gets worse.