Rob Arnott

Rob Arnott is used to antagonising people. But even he is surprised by the anger he has generated from senior executives and academics in the investment industry.

They have taken exception to his warnings published in a study last month that smart beta, an investment strategy that sits between active and passive management, could go “horribly wrong”.

His criticisms have been explosive, not least because the 61-year-old is one of the pioneers of the concept. The fact that asset managers have been queueing up to launch smart-beta products has not helped.

The outspoken former editor-in-chief of Financial Analysts Journal is the founder and chairman of Research Affiliates, which develops smart-beta strategies used by some of the world’s biggest asset managers, including Pimco and Invesco PowerShares. His words carry weight.

Still, the reaction to Mr Arnott’s concerns has caught the University of California graduate off guard.

“I thought it was going to create a little bit of a fuss, but it has created more of a stir than I expected,” he says. “There are some folks who are very annoyed.”

He sounds cheerful as he says this, perhaps because within days of the Research Affiliates study being published, Mr Arnott went on a two-week break. “I am on an eclipse trip. One of my strange hobbies is to chase solar eclipses,” he says.

Speaking by satellite phone from a cruise ship en route from the Solomon Islands to Papua New Guinea, Mr Arnott wants to make it clear that he does not think all smart-beta strategies are bad.

“Smart beta’s getting a lot of traction, and for some very good reasons. It has been working, it has been adding value for clients,” he says.

Figures from Morningstar, the data provider, support this. The numbers show assets under management in smart-beta strategies have grown from $103bn in 2008 to $616bn in 2015.

But some strategies are not doing what they claim to, he argues. He believes the soaring popularity of some smart-beta strategies will lead to a severe fall in investment performance in the next few years, leaving some investors nursing large losses.

Smart-beta funds typically take a passive investment strategy but tweak it with the aim of generating above-market returns.

The tweak makes use of so-called factors, such as value, low volatility, high yield, quality, size or momentum, or a combination of these. In a low-volatility strategy, for example, stocks that showed the most volatility over previous periods might be excluded.

Mr Arnott argues that many smart-beta strategies have outperformed the market because their underlying stocks became more expensive, not because of the factors the indices claimed generated strong performance.

“You have to distinguish between the strategies that are working, because they have some sort of structural alpha, and the strategies that are working because they have been getting more expensive. That is a very, very serious difference,” he says.

“We are not saying [smart beta] can’t add value; we are saying look before you leap.”

Mr Arnott, who has been following solar eclipses around the world since the 1990s and has now seen 14, says Research Affiliates began studying the problems with smart beta after being approached by clients who wanted quality and profitability strategies, products it does not offer.

“We were barrelling down the path of developing some of these ideas and we suddenly realised, oh my goodness, we are performance chasing, we are enabling our clients to chase performance.

“If we launch these products, we will be creating products that we believe will underperform.”

Mr Arnott does, however, believe in the benefits of fundamental indexing, the smart-beta strategy he developed more than a decade ago. It focuses on value, taking in stocks that look cheap compared with their fundamentals.

When it was first developed, he says he faced “genuine anger” from “conventional indexers and from academics, all of whom said, ‘Well, this is too simple, it can’t work’.

“Well, it did work. And then the controversy died down. I think the same thing will happen here [with the latest anger over his views on smart beta],” he says.

But while fundamental index might have gained acceptance, its performance has been less than stellar in recent years, in stark contrast to other smart-beta strategies.

Research Affiliates’ study conveniently suggests that value strategies are not overpriced. Unsurprisingly, this has not gone down well with Research Affiliates’ competitors, who question whether the company has a vested interest in promoting its own products.

Mr Arnott, who has been referred to as the “godfather of smart beta”, says there are two ways of looking at it. “When you publish something that supports your strategy it can be cynical if you are doing it because you want to persuade people to embrace your idea, whether it is any good or not,” he says.

“On the other hand, there is an absolutely non-cynical basis in which you have actually decided not to pursue products that are popular, beloved, raking in billions of dollars a month, and you have decided not to pursue it because it is expensive.”

Good press is something Research Affiliates is in need of. The company’s assets under advisement have fallen more than $10bn to $157bn in the year to the end of 2015.

But the Newport Beach-based company still has strong backing, not least because of the presence of Mr Arnott, who has no plans to stop courting controversy any time soon.

“When I come across an element of conventional wisdom, I ask, ‘Gee, has anyone tested this?’ The simple fact is that lots of received wisdom has never been tested,” he says. “When I find that conventional wisdom is likely incorrect, I publish my findings.”

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