Rob Arnott felt regret when emerging markets were plunging early last year.
He’d believed so much in their potential that he not only advised investors to boost allocations, he did so himself, raising the percentage of his personal wealth allocated to the asset class from 15% to 30% early last year. “I eat my own cooking,” the portfolio manager recalled in an interview in his office overlooking Fashion Island in Newport Beach. “Thirty percent in emerging markets in deep-value stocks is a big position. Bluntly, I wished I had taken it to 50%. I didn’t.”
That’s because by the end of the year, it was clear that the founder of Newport Beach-based Research Affiliates LLC, also known as RAE, was right.
Last year was a redemption for the inventor of fundamental indexes, also known as smart beta. From 2008 to 2015, he suffered as growth stocks outperformed value stocks.
RAE could be considered the equity manager for its Fashion Island neighbor, Pacific Investment Management Co., one of the world’s largest money management firms, with $1.5 trillion in assets. Arnott helps PIMCO manage $41.6 billion in 19 funds with a variety of strategies. Last year, 16 of the funds placed in the top 20% in their Morningstar categories.
Perhaps the most impressive performance was the RAE Fundamental Plus Emerging Markets Fund, which returned 35% and outperformed its peer group by 27%. The fund, which now has $1.4 billion in assets, soared from a 99th place ranking in 2015 in Morningstar to No. 1 last year.
“Rob likes to say that the stock market is a strange kind of store, because when something goes on sale, all your customers go screaming out of the store,” said RAE Chief Investment Officer Chris Brightman, who’s also a co-manager at many of RAE’s portfolios.
“Clients think you’re stupid if you buy something that’s down, until the market turns,” Arnott said.
Strong Combo
Arnott, a graduate of the University of California-Santa Barbara, was previously chairman of First Quadrant LP, the former internal money manager for Crum & Forster, and founder of TSA Capital Management, which is now part of Analytic Investors LLC.
Arnott, who founded RAE in 2002, likes to combine academic rigor with the reality of investments. He has published and won many awards for more than 100 articles in such publications as the Journal of Portfolio Management, the Harvard Business Review, and Financial Analysts Journal, where he served as editor in chief from 2002 to 2006.
In 2004, he created fundamental indexing, a strategy that provides systematic investments in companies based on factors such as revenue or dividend levels. By contrast, passive index investments are systematically made based on the company’s market capitalization, rewarding higher priced stocks that may already be over-valued while penalizing lower priced stocks that may be under-valued. Fundamental indexing is more expensive than passive indexes but cheaper than actively managed funds. It’s for investors who believe in buying under-valued stocks rather than growth stocks that are priced high, such as Tesla and Snap Inc.
“Rob Arnott is prominent in the smart beta or alternatively weighted approaches,” said Todd Rosenbluth, director of ETFs and mutual fund research at CFRA, a research provider to institutional investors. “Investors are increasingly looking to have a lower cost, regimented approach to investing. He’s been a key figure talking about these funds for years.”
Now-Popular Method
Smart beta has exploded in popularity, rising to $599 billion this year in 634 exchange-traded funds, a six-fold increase from a decade ago, according to Morningstar.
Arnott’s firm benefitted, as well, licensing out smart beta strategies to other firms. RAE nowadays oversees $179 billion in assets under management, license or as a sub adviser, up from $17 billion in 2006.
PIMCO is known for its expertise in bonds, though it’s dabbled in equities during the past decade with mixed results. It began working with RAE in 2002, and over the years has given it more work, such as announcing six new funds in 2015. Three of the funds finished in the top five in their categories last year.
While the smart beta theory sounded great, bets on value stocks were “savaged” from 2007 to 2015 when they consistently underperformed growth stocks, Arnott said. During much of that period, he said his firm beat the market, “but not by much.” In 2015, Arnott said his funds underperformed the market by 3%.
That same year, he and Brightman noticed companies in emerging markets were undervalued. Using the Shiller ratio, which smooths highs and lows over a 10-year period, they found the price of companies in emerging markets dip to below 10 times earnings. The type of undervalued companies they liked were even lower, trading at 5.5 times. By contrast, the U.S. is now trading at 29 times earnings, higher than its typical 19 times.
“We viewed that as an extraordinary opportunity,” Arnott said. “You can buy half the world’s GDP for five and a half times earnings.”
Arnott saw opportunities in emerging markets like China, Turkey, Brazil and Russia, where quasi-state run companies were in disfavor because of low commodity prices and fears of deflation. RAE boosted its asset allocation in those markets from 12% to 20% by the end of January 2016.
“This was just a sequel in a movie we’ve seen before” in prior market crashes, Brightman said. “What is predictable is after one of those events happen and the markets crater, you’ll get the opportunity to buy at extraordinarily cheap prices. Then you’ll have really good odds of having wonderful returns if you’re patient.”
