- Rob Arnott, the chairman and chief executive of the Pimco subadviser Research Affiliates LLC, helped pioneer a unique investment approach that encompass both active and passive methodologies: smart beta.
- Today, smart beta funds are responsible for $880 billion of assets worldwide.
- Arnott’s foundation as an investor was developed through reading classic, timeless material from investment visionaries that came before him.
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Investors today usually identify with one of two camps: Those who fervently advocate for active investing and those who tout a passive, hands-off approach. Thoughts around the correct methodology are highly divisive and passionately debated.
“From the beginning of my career, I always thought indexing was a great idea with a massive Achilles heel,” he said on “SuperInvestors,” an investing podcast. “And that Achilles heel quite simply is that the more expensive an asset is, the more weight you want to have of that asset in your portfolio.”
He continued: “Why would you want to own more of an asset just because it’s become more expensive?”
Arnott clearly sees this notion as illogical. To him, it doesn’t make sense to own an index where expensive companies make up the lion’s share of the indices’ weight. He wants cheap companies to comprise larger positions.
In traditional market capitalization weighed indices, when a company’s value increases so does its weighting in the index. For example, right now the FAANG cohort of stocks — Facebook, Amazon, Apple, Netflix, and Google — encompass about 15% of the S&P 500’s entire market capitalization. Over time, these stocks have become more expensive — and their influence on the index has grown accordingly.
“I said: ‘Why don’t we trying weighting a portfolio in accordance with fundamental economic footprint of a business?'” he added. “Just weighting a portfolio by the sales of the business instead of its market cap beat the market — not by 10 or 20 basis-points — but by 250 basis-points per annum, compounded.”
From that point on, Arnott was hooked — and his quest to search out more market-trouncing, niche weightings began to snowball. Lo and behold, smart beta is born.
Today, smart beta strategies encompass about $880 billion and employ a number of different weighting techniques or “factors.”
But Arnott couldn’t have developed this methodology without a fundamental understanding of value and mean-reversion.
The books that helped Arnott develop as an investor
Arnott didn’t derive his value-based approach or investment prowess out of thin air. He borrowed ideas from the best and brightest investors and applied them to his own methodology moving forward.
“I read all the classics,” he said. “I read Livermore. I read Ben Graham.”
Jesse Livermore is arguably one of the most famous stock traders to ever walk the earth. Before his death in 1940, Livermore wrote “How to Trade in Stocks,” which highlights his methodology and thinking around markets.
Another investor that left a lasting impression on Arnott is Benjamin Graham, who is commonly referred to as the “father of value investing” and responsible for authoring “The Intelligent Investor” and “Security Analysis.” Two books that are widely recognized as required reading amongst investment professionals.
He added: “I read MacKay’s book on bubbles and the list goes on and on.”
The book that Arnott refers to above is “Extraordinary Popular Delusions and The Madness of Crowds.” Throughout the text, Charles MacKay breaks down some of the most egregious asset bubbles of the past and the investor psychology that brought prices to levels that were widely disconnected with their fundamental value.