FTSE Russell Convenes | Episode 3, Season 2

Value investing is back

September 23, 2022

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When markets are turbulent and difficult to predict, often what’s needed is some wise words from someone who has been through many calm and stormy waters alike. Someone who fits that description: Rob Arnott, founder and chairman of the board at Research Affiliates. Rob founded Research Affiliates in 2002, which now develops investment strategies for over $160bn of assets under management. Suffice to say, he knows what’s important, and we sit down to discuss why indexing changed everything, why value is back and the fact that not all inflation is created equal.

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If you're averaging into what's on loved, one or two things will happen.It's a value trap and it's on its way to zero,in which case if you're slowly averaging in, you'll have lost a bit of moneyor it's a bargain, in which case if you're averaging inat the bottom when it turns, you'll have your maximum exposure.Well, that's pretty cool.Rob, you are chairman of Research Affiliates,and I wanted to say thank you so much for joining us today for this discussion.It's a privilege.Now, we're going to be talking about various aspects of financial markets.But if it's all right with you, I did want to start on the topic of indexing.We have seen the rise of indexing and trading indices over the past decadeor so.And I was wondering how you thinkthat's affected the way people invest.And, you know, what are the positivesand negatives around it?Well, it's affected everything about the markets.Firstly, you haveBill Sharpe's famous arithmetic of active management,the index funds ostensibly on the market,which means that everything that they don't own isidentically the same portfolio, which means active managers,assuming they own the rest, have collectivelythe same portfolio, but have higher fees and higher trading costs.So active managers simplycannot win at a fees and trading costs.That would be true if it weren'tfor the fact that the indexes don't own the whole market.So there's a difference there.And the indexes do trade.And not all active managers are created alike.But in general, it's a pretty good argument in the sensethat if I'm winning in my active strategies,there has to be an active manager, not an index fund, but an active manageron the other side of my trades who's willing to lose.Yeah, and if you can't answer the very basicquestion, who's the loser on the other side of your trades,then maybe you don't have as good a strategy as you think.Indexing is verypowerful and has become an enormous part of the market.That doesn't mean you can't win.There are very interesting and nuanced ways of winning.Let's talk a bit about passive versus active management.It's been asort of a big decade for passive over active management.Do you think that trend will continue?The trend will continue.It will slow when we enter a period of timethat is not dominated by growth and momentum stocksbecause indexing in and of itselffavors growth and creates some momentum.How it does so by adding new stocks that have just soaredand pushing them to new heights, droppingold stocks that are deeply out of favor and have tumbled.So it becomes a virtual circus and a vicious circle.Right.And so when you get into a cyclewhere value comes back, as it has this year, todayyou create headwinds for indexing and indexing itselfCan underperformance opportunity set.And if you start getting index redemptions,then the virtuous cycle becomes a vicious cycle.I don't think that's going to happen near-term, but I think on a long termbasis, there will be moves intoand out of indexing over the span of decades.Many interesting points there about growth, growth against valueand the fact that indexing, if I understandcorrectly, can sort of exaggerate moves on the upside and the downside.So so this year, in 2022, as we move into a potentially higherinterest rate environment, do you feel thatgrowth stocks may now underperform for a sustained period of timeand it's really an area for value stocks to perform?I would say emphatically yes.But for the patient investor will value whenover thenext three months, six months, 12 months, I have no clue.Will value stocks went up for the patient investor over the coming 3 to 5 years.I'd give that very, very high odds.And it's not because of interest rates.Interest rates. The narrative is low.Interest rates are a boon for growth stocks because you're takinglong term growth in earnings and dividends and your discount rate drops.So the net present value of that growth increases.So growth stocks are worth more relative to value than they used to be.Well, that's fine.If interest rates weren't also tied to economicgrowth and economic growth expectations.Right.In point of fact, if you look internationallyand across time, you find that the link with interest rates is very weak.The link with inflation is not.The link with inflation is powerful.And what we find is that periods of moderate to high inflationare wonderful for value stocks relative to growth, and that periodsof low and falling inflationare strongly beneficial for growth stocks.If I may play devil's advocatefor one second, do you therefore see all inflation as equal,or do you think that it matters what kind of inflation was saying?That's a very nuanced question and I appreciate you asking it.Not all inflation is the same, not all deflation is the same.Inflation is a bad thing.Depending on thenature of the inflation, it can be a very bad thing.Deflation, if it's tied to depressionand collapsing demand, is a very bad thing.But deflation that's due to technological innovationand soaring productivity, that's a good thing.Central bankers and I've talked to some of them, don't get that.They think that all deflation is horrible and must be avoided.I'm sorry.When you have technological innovation increasing productivityall over the world, a little deflation is a wonderful thing.Now, the inflation that ispernicious is the kind that is sustainable.Right now, we're looking at inflation that is not transitory.On a short term basis.It might be transitory in a five year horizon.Why do I say that?Because inflation is higher than what's being reported.And that means that the reported inflation has upward pressuregoing forward for some quarters to come.What's the underreported inflation?40% of CPI inflation in the US is shelter.Most of that is home owners.Back in 1982, the Bureau of Labor Statisticswas so alarmed at what soaring home priceswere doing to CPI inflation, causing it to brieflyhit 14% in 1980.That they said an owner doesn't feel the rise in their home price.What they feel is the rise in the rental equivalent value of the property.So let's switch to something called owners equivalent rent.What is that?You survey thousands of people every monthand you ask them, What do you think your home would rent for?Now, if I ask 100 people, doyou have a reasonably accurate perception of what your home would rent for?You'd find 95 out of 100 say, no, I haven't a clue.The result is that people pick a number out of the airand then they anchor on the past.What did I say last last time you asked me?4000. Now let's say 40.100. Hmm.And so what we had in 2020 and 21 is homeprices in the US rose 32% in two years,and owners equivalent rent rose 6%,2% in 20 and 4% in 21.The 26% differencewill show up in owners equivalent rent in the years ahead,about half of it in the coming three years.And the result is that owners equivalentrent will be elevated, sharply elevatedupper single digitsover the next 2 to 4 years.Okay.So if you have40% of CPIshowing high single digits, how are you going to get back down to 2%?So we're going to see this inflationhas legs will continueat least through 2023,probably through 2024, longer than that.Who knows?Depends on what our policy elite decide to do.It could continue or it could be reined in.When you say it could be reined in, there is some discussion as towhether central banks even have the power to maintain inflationat a lower level, because this seems to be sort of supply drivenrather than demand driven, which is usually what they can control.So in that respect, how much confidence doyou have in central banks being able to keep inflation under control?Central banks believe they can forecast.They can't believe that they can influence the economy.They can.But but the more in the direction of doing harm than good.There was a Swedish economist named Knut Waksalabout 100 years ago who pioneered work on the natural interest rateand because everyone was on a gold standardat the time, think of that as the natural real interest rate.His argument was if theif the rate of interest, real interestis abnormally high, it will stifle innovation.It will cut off avenues of economic growthand it will do damage if the rates are too low.Anyone who can borrow at those low rates, be it a corporation, an individual,or a government, will start to waste moneyand will start to engage in an malinvestment misallocationof resources and a diversion of resourcesaway from truly interesting,pioneering innovations which won't have access to that cheap capital.I wanted to ask you about digital assets and whether you think they are apart of the investment universe which is going to continue to grow,or do you think there will continueto be more cynicism around it, or will regulation stifle that?Where do you sit?I'm not an expert in this area, so these are all just opinions, butit seems to me thatgovernment doesn't like anything that's out of its control.And so the likelihood is that regulations,tax policy and so forthwill rein in the growth opportunities.As a libertarian, I'm an enthusiast for thingsthat allow people to do what they wantand to innovate how they want as long as they're not hurting each other.So digital currencies, cryptononfungible tokens, you name it, I'm fine with those.I think they're wonderful innovations that may be very interesting.I do question what are they good for? Hmm.The story is these can replace a reserve currency eventually.Well, for a currency to be useful,the purposes of money are very simple.You need to have a unit of measure how much is something worse?You need to have a medium of exchange.My hours of work for groceries in a grocery store.You need to have a stable store of valueso that your currencya year from now is worth approximately what it is today.Crypto fails all three dimensions.So it ishard for me to see how crypto can supplant any currencies,whether it's the El Salvador currency, where it's now the official currency.Yep, that's an experiment that seems to have not gone very wellor to eventually supplant the dollar as the reserve currency.I count me as one of the skeptics and the mechanism by which it doesnot happen, I think is mostly a matter of government intervention.And if I may ask you a more global questionalong the lines of geopolitical tensions and de-globalization.How do you see trade and relationships generally developingbetween countries and continents?Boy, that's a very challenging question.I like to look at world events,whether they are political or economic orat the micro level, individual companies and individuals behaviorsthrough aprism of will it still matter in five years.Now, Ukraine is very, very distressing,and it pains me to say this, butone of two things is likely over the next five years,Putin will have his corridor to Crimeaor Ukraine will remain whole and Putin will be gone.Putin sees this as an existential threat,which he put on himself through his own actions.So this is not going to end gracefully,but roll the clock forward five years.Will either Ukraine whole and rebuildingor partitioned and rebuilding matter on the world stage?Will it matter to the world economy?Not really.COVID is not going to matter in five years.It's already for those who have been vaccinated,no more dangerous than average flu.Um. Unprecedentedspending in response to COVID and the resulting debt burden.Wow. That's going to be with us for a long time.Yeah.So this gives us an Occam's razor to decidewhat's going to matter in five years.What should I focus on?A friend of mine in the business, Charles Goff,of all things, a really good French economist.Hard to imagine, but a really good French economistlike to talk about the media and the marketsin a context of what are these bastards trying to distract me from?I love that that way of framing it because the media focuses on narratives.Narratives set prices for assets,changes in the narratives, move asset prices.So it's often wonderful to askwhat's the dominant narrative today,and will it still matter in five yearsif it's not going to matter in five years?Then ask the question Which way will this have moved markets and bet against it?Not asking for investment advice per se, but for those looking to buildor re re align their portfolios right now in 2022,What what do you think people should really be looking to do, whether it'sput more into alternative assets or be more conservative.In terms of specifics, I think more intoliquid alternatives is a good idea. Why?Because mainstream stocks and bonds are expensive and the yields are too low.Which alternatives? non-U.S.stocks and emerging market stocks and bondsare all priced much more reasonably than USnon-U.S.bonds outside of the emerging markets.That's another story.Those yields are near zero in terms of general guidelinesthat would be more lasting in nature thanmy prescription for right now.One issue is to ask the questionwhat is popular and hot now and avoid it? Yep.What is out-of-favor and unloved now?Average in. Mm hmm.If you're averaging into what's unloved, one or two things will happen.It's a value trap, and it's on its way to zero.In which case, if you're slowly averaging in, you'll have lost a bit of money.Or it's a bargain, in which case, if you're averaging inat the bottom when it turns, you'll have your maximum exposure.Well, that's pretty cool.Rob, there's been some excellent nuggets in thereand I've really enjoyed chatting me today.So I just want to say thank you so much for our conversation.It's been really great. This has been great fun.

Video recorded on June 2, 2022 at World Investment Forum

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