Warning of a Crash - strategy has become too popular

Opinion: ‘Smart-beta’ investing guru is now warning of a crash

Published: Feb 25, 2016



Rob Arnott says the popular strategy has become too popular

By BrettArends

Columnist

Dump “quality” stocks and buy “value” stocks.

That’s the call from Rob Arnott, the legendary financial guru and chairman of Research Affiliates, an investment firm in Newport Beach, Calif.

He says stocks bearing high-quality characteristics — such as high profits, strong balance sheets and so on — have now become far too expensive in relation to the rest of the stock market.

Meanwhile, so-called “value” stocks — which generally mean boring companies that have low future growth prospects but are cheap in relation to current profits and dividends — are at one of their biggest discounts in modern history.

Arnott’s latest research is a salutary warning that smart beta, like anything, is subject to the laws of financial gravity, known in the trade as ‘mean reversion.’

Arnott’s call may be useful for investors looking to find the best bargains. But how he reaches this conclusion is equally fascinating.

The big trend in investing since the financial crisis has been the discovery of so-called “smart beta,” which means investing in stocks based on characteristics like low volatility, high quality and high momentum.

A ton of academic research has found that such strategies would have earned you higher returns with lower risk over many decades if you had followed them.

As a result, there’s been a flood of mutual funds, exchange traded funds and institutional portfolios designed to help investors profit from the “alpha” of “smart beta” — which is Wall Street jargon for saying they hope to make you lots of money.

Arnott was among the pioneers of this research, and is one of the most respected names in finance. So why has he turned against it?

Simple. Smart beta has become so popular, it’s now dangerous, he says. Indeed, a “smart-beta crash” is now “reasonably likely,” he warns.

A stock is worth only the present value of its future cash flow, just as, say, investment property is worth only the present value of its future net rents.

The more you pay for the investment, the less a bargain it is. During a mania, a fad or a bubble, people end up paying too much. So even though the future cash flow (or net rents) flow through, the investor loses money.

Historically, you’ve done very well if you invested in the stocks of companies that had high business quality (such as high profits, low debts, stability and so on), and in stocks that had low volatility. You made more money, with less risk, over time. Hence the rise of “smart-beta” strategies that targeted such stocks.

But as more people discovered these phenomena, they joined in the demand for smart-beta stocks – and drove up the price. At some point, while the business remains one with high quality or low volatility, the stock

And there’s a further, dangerous twist. 

 

As an investment fashion becomes more popular, people drive up the price. But as they drive up the price, they then start factoring that extra bump in valuations into their forecasts for the future. 

 

So people get even more bullish while they should be getting bearish. It’s like jumping on a seesaw at the top and thinking it’s going to keep going up.
Arnott’s latest research paper is a salutary warning that smart beta, like anything, is subject to the basic laws of financial gravity, generally known in the trade as “mean reversion.” If you wanted to bet against it, you’d go out right now and buy the lowest-quality stocks, on the basis that they are out of fashion and therefore the best relative bargain.

There are, however, less drastic alternatives. Arnott finds that simple, old-fashioned “value” strategies — which invest in the stocks that are cheap in relation to present profits and dividends — look like a bargain now. Value stocks have outperformed growth stocks by around 3 percentage points a year over the long term. But they are currently near historic lows in relative terms.


“The value effect is … in its cheapest decile in history,” he says. Value is out of fashion, partly because it’s looked bad for the past seven or eight years, and partly because investors have become excited by smart beta instead.

Or, as always, one could simply pick a random collection of stocks and invest an equal amount in each one. Equal-weight strategies, like value, have beaten the traditional indexes over the long term. And they would seem to be immune from fashion, because they don’t weight anything at all.

 

 

 

 Source: http://www.marketwatch.com/story/smart-beta-investing-guru-is-now-warning-of-a-crash-2016-02-25