Khanchit Khirisutchalual
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.
Rob Arnott: If you’re averaging into what’s unloved, one of 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 in at the bottom, when it turns you’ll have your maximum exposure. Well, that’s pretty cool.
Jamie McDonald: Rob, you are chairman of Research Affiliates, and I wanted to say, thank you so much for joining us today for this discussion.
Rob Arnott: It’s a privilege.
Jamie McDonald: 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 in trading indices over the past decade or so. And I was wondering how you think that’s affected the way people invest and what are the positives and negatives around it?
Rob Arnott: Well, it’s affected everything about the markets. Firstly, you have Bill Sharpe’s famous arithmetic of active management. The index funds ostensibly own the market, which means that everything that they don’t own is identically the same portfolio, which means active managers, assuming they own the rest have collectively the same portfolio, but have higher fees and higher trading costs. So active managers simply cannot win net of fees and trading costs. That would be true if it weren’t for 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 sense that if I’m winning in my active strategies, there has to be an active manager, not an index fund, but an active manager on the other side of my trades, who’s willing to lose.
Jamie McDonald: Yeah.
Rob Arnott: And if you can’t answer the very basic question, 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 very powerful 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.
Jamie McDonald: Let’s talk a bit about passive versus active management. It’s been a sort of a big decade for passive overactive management. Do you think that trend will continue?
Rob Arnott: The trend will continue. It will slow when we enter a period of time that is not dominated by growth and momentum stocks because indexing in and of itself favors growth and creates some momentum. How? It does so by adding new stocks that have just soared and pushing them to new heights, dropping old stocks that are deeply out of favor and have tumbled.
Jamie McDonald: So it becomes a virtuous circus and a vicious cycle.
Rob Arnott: Right. And so when you get into a cycle where value comes back, as it has this year to date, you create headwinds for indexing and indexing itself can under performance 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-term basis, there will be moves into and out of indexing over the span of decades.
Jamie McDonald: Made an interesting point just there about growth, growth against value. And the fact that indexing, if I understood correctly, can sort of exaggerate moves on the upside and the downside. So, this year in 2022, as we move into a potentially higher interest rate environment, do you feel that growth stocks may now underperform for a sustained period of time and it’s really an era for value stocks to perform?
Rob Arnott: I would say emphatically, yes, but for the patient investor. Will value win over the next three months, six months, 12 months? I have no clue. Will value stocks win for the patient investor over the coming three to five 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 taking long-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 economic growth and economic growth expectations.
Jamie McDonald: Right.
Rob Arnott: In point of fact, if you look internationally and 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 inflation are wonderful for value stocks relative to growth. And that periods of low and falling inflation are strongly beneficial for growth stocks.
Jamie McDonald: If I may play devil’s advocate for one second, do you therefore see all inflation as equal? Or do you think that it matters what kind of inflation we’re seeing?
Rob Arnott: 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 the nature of the inflation, it can be a very bad thing. Deflation, if it’s tied to depression and collapsing demand is a very bad thing, but deflation that’s due to technological innovation and 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 productivity all over the world, a little deflation is a wonderful thing. Now the inflation that is pernicious 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 on 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 pressure going forward for some quarters to come. What’s the under reported inflation? 40% of CPI inflation in the US is shelter. Most of that is home owners. Back in 1982, the Bureau of Labor Statistics was so alarmed at what soaring home prices were doing to CPI inflation causing it to briefly hit 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 owner’s equivalent rent. What is that? You survey thousands of people every month and you ask them, what do you think your home would rent for?
Now, if I ask 100 people, do you 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 air and then the anchor on the past. What did I say last time you asked me? 4,000. Well, let’s say 4100. And so what we had in 2020 and 21 is home prices in the US rose 32% in two years. And owner’s equivalent rent row 6%, 2% in 20, 4% in 21. The 26% difference will show up in owner’s equivalent rent in the years ahead, about half of it in the coming three years. And the result is that owner’s equivalent rent will be elevated, sharply elevated upper single digits over the next two to four years.
Jamie McDonald: Okay.
Rob Arnott: So if you have 40% of CPI showing high single digits, how are you going to get back down to 2%? So we’re going to see this inflation has legs. Will continue at 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.
Jamie McDonald: When you say it could be reined in, there is some discussion as to whether central banks even have the power to maintain inflation at a lower level, because there seems to be sort of supply driven rather than demand driven, which is usually what they can control. So in that respect, how much confidence do you have in central banks being able to keep inflation under control?
Rob Arnott: Central banks believe they can forecast. They can’t. Believe that they can influence the economy. They can, but that more in the direction of doing harm than good. There was a Swedish economist named Knut Wicksell about a 100 years ago, who pioneered work on the natural interest rate. And because everyone was on a gold standard at the time, think of that as the natural real interest rate. His argument was if the rate of interest, real interest is abnormally high, it will stifle innovation, it will cut off avenues of economic growth, and 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 money. And will start to engage in mal-investment, misallocation of resources, and diversion of resources away from truly interesting pioneering innovations, which won’t have access to that cheap capital.
Jamie McDonald: I wanted to ask you about digital assets and whether you think they are a part of the investment universe, which is going to continue to grow, or you think there will continue to be more cynicism around it, or will regulations stifle that? Where do you sit?
Rob Arnott: I’m not an expert in this area. So these are all just opinions, but it seems to me that government doesn’t like anything that’s out of its control. And so the likelihood is that regulations, tax policy and so forth will rein in the growth opportunities. As a libertarian, I’m an enthusiast for things that allow people to do what they want and to innovate how they want, as long as they’re not hurting each other. So digital currencies, crypto, non fungible 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? The story is these can replace 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 worth. 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 value so that your currency a year from now is worth approximately what it is today. Crypto fails all three dimensions. So it is hard for me to see how crypto can supplant any currencies, whether it’s the El Salvador currency, where it’s now the official currency.
Jamie McDonald: Yep.
Rob Arnott: That’s an experiment that seems to have not gone very well. Or to eventually supplant the dollar as the reserve currency. Count me as one of the skeptics and the mechanism by which it does not happen, I think is mostly a matter of government intervention.
Jamie McDonald: And if I may Rob, ask you a more global question along the lines of geopolitical tensions and de-globalization, how do you see trade and relationships generally developing between countries and continents?
Rob Arnott: Boy, that’s a very challenging question. I like to look at world events, whether they are political, or economic, or at the micro level individual companies and individuals’ behaviors through a prism of will it still matter in five years? Now Ukraine is very, very distressing and it pains me to say this, but one of two things is likely over the next five years, Putin will have his corridor to Crimea or 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 rebuilding or partitioned in rebuilding matter on the world stage, will it matter to the world economy? Not really. COVID, not going to matter in five years. It’s already, for those who’ve been vaccinated no more dangerous than average flu. Unprecedented spending in response to COVID and the resulting debt burden. Wow, that’s going to be with us for a long time.
Jamie McDonald: Yeah.
Rob Arnott: So this gives us an Occam’s razor to decide what’s going to matter in five years? What should I focus on? A friend of mine in the business, Charles Gave of all things, a really good French economist, hard to imagine, but really good French economist, likes to talk about the media and the markets in a context of what are these b******s trying to distract me from. I love 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 ask what’s the dominant narrative today and will it still matter in five years? If it’s not going to matter in five years, then ask the question, which way will this have moved markets and bet against it.
Jamie McDonald: Not asking for investment advice per se, but for those looking to build or realign their portfolios right now in 2022, what do you think people should really be looking to do? Whether it’s put more into alternative assets or be more conservative.
Rob Arnott: In terms of specifics, I think more into liquid alternatives is a good idea. Why? Because mainstream stocks and bonds are expensive and the yields are too low. Which alternatives? Non-US stocks and emerging market stocks and bonds are all priced much more reasonably than US. Non-US bonds outside of the emerging markets, that’s another story. Those yields are near zero. In terms of general guidelines that would be more lasting in nature than my prescription for right now, one issue is to ask the question, what is popular and hot now and avoid it.
Jamie McDonald: Yeah.
Rob Arnott: What is out of favor and unloved now? Average in, if you’re averaging in to what’s unloved, one of 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 in at the bottom when it turns you’ll have your maximum exposure. Well, that’s pretty cool.
Jamie McDonald: Rob, there’s been some excellent nuggets in there and I’ve really enjoyed chatting with you today. So I just want to say thank you so much for our conversation. It’s been really great.
Rob Arnott: This has been great fun.
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