This week, you'll get a glimpse of what goes on in the mind of a true innovator in financial strategy. Hailed by Dan as the "godfather of fundamental indexing," Rob Arnott, founder and chairman of the board of Research Affiliates, returns for another provocative interview.
As promised, Dan and his co-host Corey kick things off with a mailbag special to celebrate Stansberry Investor Hour's 300th episode. Thanks to listeners like you, we've collected quite a few e-mails. So today, the duo will tackle a couple of the burning questions you've sent us.
Another milestone in today's episode comes in the form of Research Affiliates' proprietary RAFI Fundamental Index ("RAFI") strategy, which is nearing its 20th anniversary. Rob shares some history about his pioneering work that's used by industry heavyweights like Charles Schwab and PIMCO.
Since the 1990s, Rob has been toying with the idea of looking past the traditional investing strategy of weighting stocks by market capitalization. So in 2004, he and his team created RAFI, a strategy that weights a stock based on the underlying fundamentals of a business...
That's when it hit us. Why would [RAFI] consistently add value? Because it breaks the link between the weight in the portfolio and the price of the stock. If the price doubles and the underlying fundamentals don't, the fundamental index will say, "Oh, trim it." If a stock tanks and the fundamentals don't, the fundamental index will say, "Thanks for the deep discount – I'm topping it back up," which means you get a rebalancing alpha [...]
So when you contratrade against the market, you're capturing a rebalancing alpha. But you're also creating a value tilt because the growth stocks are reweighted down to their economic footprint and the value stocks are reweighted up to their economic footprint. And the result is you have this stark value tilt.
He back-tested the strategy with 500 of the largest stocks weighted by sales using 30 years of data. The result? "A lot of active managers would sell their grandmother to get to 2.5%," Rob quips, referring to how much RAFI outperformed the S&P 500 Index.
Rob also warns against following the herd by explaining what happens when you mix availability bias and a bubble. And, with the help of monkeys, he shares how inherently flawed the traditional idea of weighting only by market cap can be... In a nod to economist Burton Malkiel – who once wrote how a blindfolded monkey throwing darts could outperform a fund manager – Rob and his colleagues simulated the monkey for one of their research papers...
On average, the monkey portfolio beat the S&P by 160 basis points a year. That's just from breaking the link with price. Fundamental Index breaks the link with price but still keeps the link with the underlying fundamentals, meaning you're not loading up on tiny companies that are hard to trade – you're loading up on big businesses which are usually large-cap stocks.
You're going to underweight the Teslas of the world and overweight the Chevrons of the world... because Chevron is out of favor, unloved, and relatively cheap, and Tesla is beloved, frothy, and expensive. But you'll still own both of them, and you'll be earning money from the market's constantly changing opinion of what Tesla is worth or what Chevron is worth. And because it's weighted in accordance with the size of the business – and the size of the business doesn't change very much from year to year – the [portfolio] turnover is shockingly low.
Founder and Chairman of Research Affiliates
Rob Arnott is the founder and chairman of the board of Research Affiliates, a global asset manager dedicated to profoundly impacting the global investment community through its insights and products. The firm creates investment strategies and tools based upon award-winning research and delivers these solutions in partnership with some of the world's premier financial institutions. Rob plays an active role in the firm's research, portfolio management, product innovation, business strategy and client-facing activities.
Dan Ferris: Hello, and welcome to the Stansberry Investor Hour. I'm your host, Dan Ferris. I'm also the editor of Extreme Value and The Ferris Report, both published by Stansberry Research.
Corey McLaughlin: And I'm Corey McLaughlin, editor of the Stansberry Digest. Today, Dan interviews Rob Arnott, founder of Research Affiliates.
Dan Ferris: It's our 300th episode, and we'll celebrate with lots of feedback and questions from the mailbag.
Corey McLaughlin: And remember, if you want to send us an email, you can send your notes to [email protected] and tell us what's on your mind.
Dan Ferris: That and more right now on the Stansberry Investor Hour.
Well, happy 300th episode, partner.
Corey McLaughlin: Well, yes, happy 300th. I feel I've been on here for maybe a dozen or so. So, I'm just kind of enjoying the cake, and you did most of the heavy lifting. So, congratulations to you.
Dan Ferris: Thanks. I don't know how many I've done. I think it's around 260 or something like that.
Corey McLaughlin: Eh, just a casual 260.
Dan Ferris: Yeah. Well, you do one a week since like 2018. But it's been fun. It's been a lot of fun, and just getting to know and interview all of these extremely interesting people. I mean we interviewed Annie Duke three times. It was awesome... and Rob Arnott twice and John Stossel, Ron Paul, all these people. It's just incredible, so I'm having a good time.
Corey McLaughlin: Yeah, good. I like listening and now I'm enjoying more and more being a part of it. Happy to do it.
Dan Ferris: All right, to celebrate, we're going to the mailbag again. I think maybe Corey and I will just take turns. I know we've both been through the mailbag, and we've each got some questions that we found interesting. I'll start off with Jerry S. because he's got a very simple question here. It's a couple of them. He says, "When do you recommend converting some of my stock to gold and what percent of your investment of stock should be for gold?"
I think that sounds like you want to buy stocks and buy physical gold, but you're also curious about maybe what percentage of your equities should be gold stocks? I think you might be asking that. Nothing is set in stone. It's up to you. You need to decide how much you want in anything. I don't know how old you are. I don't know what your risk aversion or your risk tolerance in general is. I don't know a lot of stuff about you.
As far as converting some of your equities into gold, like selling stocks and buying physical gold, I don't specifically recommend that. Whether or not you want to raise cash to buy gold by selling stock, that's up to you, Jerry. I just think everybody ought to hold plenty of cash, plenty of really good companies that they've purchased at reasonable prices and own some gold and silver as well. As for a percentage, I think in general, when I say plenty of cash, I think I mean at least 20% relative to your equity portfolio, relative to your liquid investments, the stuff that you manage on an ongoing basis. You could do a similar number with gold, like over time I've heard many people in and around the gold investment community, if you can say there is one, say 5% or 10% of your liquid assets in physical gold. Maybe just start with those as general guidelines, and then decide what you'd like to do for yourself.
All right, Corey, what have you got for me?
Corey McLaughlin: Yeah, just following up on yours real quick, just your answer. I would say that cash level that Dan suggested sounds very reasonable to me. If you're closer to retirement or in retirement, you might want that level a little higher than if you're a decade or so out and still have time to be in the market and recover from any downsides that may come up and that sort of thing. Yeah, not too much more from me on that one.
I've got another from Doug M. This is going back a little while to our discussion – I guess probably our first discussions on tech layoffs. He says, "Hello, Dan and Corey. I love your thoughts on these podcasts. Your take on the tech layoffs is partially off in my opinion." He says, "I've been in this industry for decades. From what I'm hearing and seeing is that developers make up a small percentage of those that got laid off. I'm seeing a large number of newly added positions being hardest hit. Sales and marketing tend to be the first, etc. Just my two cents."
Well, thank you for your two cents, Doug, and this was back, I think, when we were talking about maybe Twitter or some of the other tech companies maybe. I think we'll just go with Twitter right now, because we were talking then how maybe it was getting buggy and the platform was getting buggy and whatnot, and it just was not working, just was not working.
I think that's what we were talking about, but yeah, I think I've seen a lot more stories recently about exactly what Doug's saying. A lot of tech companies had overhired in the boom of 2020 –the work-at-home environment of 2020, and now a lot of those positions are going away, including people that may have just got hired not too long before they got laid off, which shows you how quickly the economy and the environment is changing. I think it's something that I'm going to keep watching as far as who's getting laid off, how much further these layoffs go and what other type industries they hit because that's going to affect all kinds of things. So as the Fed-tightening cycle continues or ends, and how that affects businesses' bottom lines, in part, that's one of them. We'll keep talking about this.
Dan Ferris: We will. I think you've covered it. I feel like Charlie Munger. Nothing to add. [laughter]
Corey McLaughlin: No. That's usually what I like to say.
Dan Ferris: The next one that I have comes from Mark R. Mark R. says, "Do you think coal will participate in this commodities supercycle you talked about recently?"
Man is this a good question. As soon as I saw it, I thought "yes." I want to say "yes," but because we've seen these stories in Germany. They ripped up a whole town – I think it was already abandoned, but they're just ripping stuff up so they can mine coal deposits because they screwed up... They got too into green energy, and they restricted fossil fuels too much too soon. I don't know, people seem really devoted. Governments seem really devoted to these targets. If that's true, they're going to keep trying to get rid of coal, and I think they're going to be harder on coal than they are on other things. Over time, I think the green agenda will fall apart. All these targets are – you see dates like 2030, 2035, and 2050 are three that I often see for green-energy targets and zero carbon and net zero, whatever you want to call it.
I think before we get there, there will be a lot of backlash and there will be a lot of realization that, "Oh my God. This means we need to open a new copper mine the size of the world's largest copper mine which produces a million tons every year, [laughter] and we need to open one of those every year between now and like 2040 or something." So yeah, people are going to start figuring that out. They're going to start figuring out that cobalt is mined in Africa by children in the worst circumstances, and they're going to [laughter] – what's her name? Greta Thunberg got arrested. I think it was a put-on, but she was allegedly at a protest for some – she was protesting wind turbines [laughter], which I found odd. [laughter] So anyway, Mark, I think it will participate overall. I think really the bottom line is the answer is yes, but you need to keep an eye on it because it's a target.
Corey McLaughlin: I agree with you. I'm looking at a chart of coal futures right now. They're still, after being down 50% in the last year, are still up four times from 2020.
Dan Ferris: [laughter] Right.
Corey McLaughlin: I remember during 2020 and 2021, I was watching coal prices and it was just boggling my mind and so yes, I think there will be ups and downs for it, but I do think it'll go higher before it is not used at all ever again. I think there's room for, like Dan said, there's a lot of targets for certain new energy sources, but I don't think the old ones or the current ones are going to just go to zero anytime soon.
All right, I'll go next here. We've got Pete S. who says, "I sure enjoy your Stansberry Investor Hour. Thank you both for putting it on the air. What are your favorite resources for finding investments and deciding what to do with the investment possibilities?"
Well, thank you for the question. I will start this off briefly, and then maybe if Dan wants to get into it a little bit more since he actually picks stocks and I don't, but honestly, from my point of view, and I write the daily Digest as you might know or might not know. I read all of our Stansberry stuff, and all the research from all the editors and analysts, and I don't know if that's the answer you want to hear or not, or if you're asking how they actually go about picking their stocks. I mean Dan could speak more to that than me, but if you're looking at it from a subscriber point of view, I always like to say, "Read everybody at first, and then you'll find what fits with your style and goals and what you're trying to accomplish with your money, which is the first thing to think about, and then just follow those people." When a lot of different analysts come settle on the same idea from different perspectives, that usually sets off alarm bells in my head as well to highlight that, and that may be something worth looking at, and definitely not ignoring. I guess that's what I would say there.
Dan Ferris: Yeah, what was the wording here? The resources? How did she put this?
Corey McLaughlin: Yeah, he said, "What are your favorite resources for finding investments and deciding what to do with the investment possibilities?
Dan Ferris: OK, so for finding investments and deciding what to do, boy are they two different things. So, finding the ideas to begin with, so Mike Barrett does something for Extreme Value where we make a list of all the companies we already know we really like. Mike compares that to a model that we use for valuation, just on a regular basis – daily, really. When something gets cheap and gets attractively priced, we start to get real interested. So, we have that. That's one way that we find investments to pull the trigger on. Another way that's sort of a step before that is I use stock screeners. Stock screeners are all over the internet. I do happen to use a very powerful one that is on Bloomberg, but there's powerful stuff all over the internet.
So even if you don't want to spend however many thousands of dollars a month it is for a Bloomberg terminal, you can screen stocks in a very, very powerful way. I screen the five clues: gush free cash flow, consistently thick margins, great balance sheet, and I actually don't usually include – the only way that I've screened for share purchases or dividends is just to see if the share count falls over time, and then ROE. I just put a minimum ROE. I keep it really low too. You want to bring in more names rather than fewer when you're screening, because that's an initial screen. So, I set it at like 10% or 12% or something low just to see what pops up. So those are some resources for just finding ideas. Now, for deciding among them all...
Corey McLaughlin: Yeah, uh-oh. [laughter]
Dan Ferris: That's a little different [laughter]. Maybe we won't even get into that right now.
Corey McLaughlin: Yeah, that's a long question. We covered a little bit of it earlier with the cash and gold allocations. That sort of idea you apply to risk and how much you're willing to bet on a certain stock or not depending on a lot of different variables, I would say. Yeah, maybe we'll get into that another time.
Dan Ferris: All right, I've got one here from Steve. E. Steve, you ask a lot of questions. I'm not going to be able to get to all of it, but I'll take your last one first real quick. "No one is paying attention to how low the commodities oil, natural gas, copper, uranium, and even some good quality gold stocks are positioned. Can these commodity investments be a key component to a setup for the next three to five years as demands for these commodities soar as supply right now is very low? Thoughts? Thank you, Dan, Steve E."
Steve E., yeah, I really like these now. I just published a report for Extreme Value premier subscribers that has seven of what I believe are the absolute best highest-quality names that do produce oil, natural gas, copper, uranium, gold, silver, and a few other things.
So, I like this idea a lot. I think the time is great. I think we're headed into a supercycle that could turn into a hypercycle because we don't invest in these things. Like the oil and gas situation is emblematic. When you tell people you're going to put them out of business, they get real shy about putting money into holes in the ground that isn't worth it unless it's going to be able to produce for 20 years or more. You don't make 20-year investments when somebody says they're going to put you out of business in seven years or so. [laughter] The supply is just not there. You can just look around. They haven't found huge new copper deposits and to do all this green-energy stuff, you're going to need a new largest copper mine in the world every year for the next several years. So yeah, I think this has legs and I think it'll be a good trade for, you said three to five years. I think it might actually go longer than that, but who knows? But three to five is a good, good start. So yeah, I like that a lot, Steve.
Corey McLaughlin: All right, I'm Charlie Munger on that one. Nothing to add. I got another one here from Richard E. This is a great comment. "If you can figure out a way to talk to those of us of a certain age that you have helped very well over the years, we need some guidance on how to handle enough, how to begin to define it, and how to use it judiciously. We spend much time accumulating it and don't spend enough time thinking about it going the other way. Money is a tool. The purpose of gaining is to someday spend some of it. Lots of us struggle with how to switch mindsets."
Great deep thought here. My first initial thought is I'm a little younger [laughter] and don't think I have enough. So, I'm probably not the best person to answer this question. My second thought is maybe we could get a guest on who specializes in this sort of idea. My third thought was, Dan, do you have any thoughts? [laughter]
Dan Ferris: I absolutely do. This is something that has been on my mind like this morning. Before I heard this question – I didn't hear this question until later after I had these thoughts. I got up very early, earlier than usual, and I was thinking about this very subject, and I thought, "You know, I've accumulated what I've accumulated, and it's really nice, and I'm happy about it." I thought to myself, "Really, what I want to do" and I know the questioner said, "We want to forget about this, and we want to spend some of it and enjoy our lives", it sounds like. But for me, the spending is the issue. Spending gets to be a habit, and it's not even that I don't have enough money to cover the things I spend. It's that spending eats up too much of my attention.
I feel like, especially since I'm in front of my computer all day, I'm shopping mostly for books, which is mostly for work purposes these days. But I also wind up looking at other things – guns, and clothes, and watches and things. I'm like, "I need to stop shopping." I think if you do that, you are going to instantly improve your quality of life. Put your phone in another room. Get that out of your life and do the things that we all did before we had these phones just attached to us like – it's like a cancer cell or something. I think do those things. Spend less time in front of screens. How about that? That's my prescription. Spend less time in front of screens and you will know when enough is enough. Your experience of enough has more to do with where your attention is focused. Focus on your kids and your grandkids and your wife and your relationships and getting outdoors and doing healthy things and get away from screens.
Corey McLaughlin: Yeah, the prescription for getting away from screens is – I don't think can be said enough today. I look at people in my family who I haven't seen in a while and then when I see them again, they're just so different. Their heads are in their phones... and I'm guilty of it myself. I'm sure I'm the same way. People you knew 10 years ago look completely different how they behave day to day, which is going to happen. People change, but I'm talking about the amount of time you spend on your phone. So, if you're trying to think about having enough, the phone is just full of distractions. It's designed to distract you and get you to buy things and click on whatever it is. We're probably guilty of it. We send out a lot of emails and have social media accounts and all of the other things.
Dan Ferris: We're big distractors. [laughter]
Corey McLaughlin: Right, but [laughter] so I'm – what am I saying? But I think it goes back to what Dan said. You've just got to think about what's important to you and really sit down and think about it. Most people don't even take 30 seconds to think about what is actually important to them. They just roll through and go through the day to day and get angry at things, whatever it may be. I think really just sit down and write down something on an actual piece of paper or a digital notepad like I like to use. But just think about some of the things. What is enough to you? What is really important? Is it family? Is it doing something that you haven't been able to do before, or something that you think you can't do, or haven't been able to do?
Chances are you could probably do it if you find a way, and it means enough to you. Money, thankfully, it sounds like you have enough that you're able to do those things, or not do anything. That's maybe what he's getting at here because you're right. Getting rich should not be the goal. It should be having the freedom to do the things that you want to do with the money – and have enough money that you're comfortable to do that. At least, I think if just the air quotes, "getting rich" is the end goal, you're going to be disappointed at the end because who am I to say? But from people that I've heard go through this sort of thing, if you have enough to do what you want to do, I think that is enough. Maybe that's the answer.
Dan Ferris: Maybe that is. Yeah. I think you'll get to enough by considering worthwhile, and realizing you don't have forever to do it, but yeah. I think we're on the same page here. I have one more by Seth C. He says, "Greetings Dan and Corey. In your latest episode of the Investor Hour" – this was a few weekends ago with Brian Tycangco. It was interesting – "I have heard there are many issues with building electric vehicles due to the mining of cobalt, which is mined almost exclusively in the Congo. I saw some detail on that on Joe Rogan's podcast, and I was surprised by how much cobalt is in many of their devices today including electric vehicles. What are your thoughts on that? Seth C."
I mentioned this before, Seth. I think there's going to be a lot of backlash against all the technologies that the green revolution is now pushing, including solar and wind. I think they're going to find out that they're both terribly, horribly inefficient ways to produce electricity. They have all kinds of materials in them that come from places like the Congo that must be mined. The green revolution requires so much mining that it just boggles the mind that you would think these people would be behind it. They obviously have no idea. Once they do get an idea, I think they'll be protesting the cobalt mining in Congo and not worrying about whether they're protesting the coal-fired power plant or the natural gas-fired power plant, or the oil-burning cars.
Corey McLaughlin: I love all the commodity questions. This is going to be a huge story. You're right. [laughter] When people realize what things are in these "new energies". They're just old things in the ground. Yeah. But this happens. Culturally, at least in America, we get focused on one thing. "This is the worst thing in the world. This is the worst thing in the world. Oh, here's five to 10 consequences of it that we need to deal with 10 or 20 years from now." It just happens over and over again. This is a big one in terms of energy.
Dan Ferris: OK, I lied. I didn't have one more then. I have one more question now. I did have one more. So, this is Ricky H. Ricky H. wants to know, "Can you please discuss why deflation is so feared? Agriculture and technology of all sorts should naturally cause prices to go down. So why do we accept that they must go up instead? Thanks, Ricky H."
Yeah, we accept it because we live in a fiat currency world.
Corey McLaughlin: Bingo.
Dan Ferris: That's why we accept it. The century from the end of the Napoleonic Wars to the beginning of World War I was the century of deflation largely during that time. There were exceptions, but mostly from 1815 to 1914, it was a century of deflation. Then in 1914, what happened? Well, the Federal Reserve started in business that year. Federal Reserve Act was passed in 1913, but it started operating in 1914. Ever since then, the value of the dollar has gone down, down, down, down, down. Every now and then we get these inflationary episodes. So, people are scared of it. A lot of it is lingering from the Great Depression. People fear another episode like that.
Of course, a lot of that was caused by the government artificially trying to jack up the prices of things. It was a mess. It's a great question though, and it shouldn't be feared. This idea that the Fed is always trying to engineer the optimum level of inflation is bogus. They can't do it. They've never done it. They never will be able to do it, and they'll only cause more problems by trying to do it. Ricky, you are spot on with this question. It should not be feared. It should be normal. The cost of things should come down over time and humanity – as humanity becomes wealthier due, as you correctly point out, to advances in things like technology and agriculture and all sorts of things. Good question.
Corey McLaughlin: Seconded. Very good. All right, I've got one more from Twitter, if I can find it here from Joe M. "What financial belief do you hold to be true that most others do not?"
Wow, another good, deep question here. It's a little difficult to answer because I don't know what others believe [laughter] mostly? I don't pretend to think that everybody thinks the same way. Maybe they do, but one I guess just using my own background in history, I would say, is that you can't manage your own money or you don't need to be scared of money either or how to handle it. If you're listening to this podcast, you've probably gotten past that [laughter] part a long time ago hopefully. I would say to try to remember that. When you hear a lot of people in the mainstream say, let's use the 60/40 stock/bond portfolio as an example. That was the conventional consensus thinking for the bulk of millions of people's portfolios heading into 2022, and it literally had the worst year of all-time [laughter] with that allocation.
I know a lot of people got caught up in that, and honestly, looking back on it, it wasn't that difficult to see. We had super-expensive stock prices and interest rates that couldn't go any lower. That's bad for stocks and bad for bonds. It's a simple way to say it, but my point is if you can think about these things independently enough, and the good thing about being your own person and not a Wall Street hedge fund or whatever if you have the ability to do these things. You're not beholden to any benchmarks or anybody else really except yourself. I think the idea that think for yourself is so valuable, and it's all we can really do. If you hand that over to just conventional wisdom a lot of times, you'll get the conventional results. If you do the average things, you'll get the average result. In a year like last year, the average thing was not very good at all.
Dan Ferris: That's a great answer. It's an interesting question for the reason you point out. What do other people think in the first place? They think a lot of different things. But mostly when I'm thinking about this question, I'm thinking about the common foibles of human behavior. We talked about this recently with Annie Duke. The big mistake that a lot of people make is that they cut their winners and they let their losers run. I think you should regularly keep an eye on what's not working, but even then, even then, I think overall, the thing that most people don't do is they're not patient. Actively managing doesn't mean you're trading every day, but Corey's right. You should actively manage. You should just learn to be very, very patient, and that is what people don't do. That is what I advocate that I think many people talk about it, but they don't actually do it, and you should. You should learn to hang onto a great stock for a long, long time. Once you buy Berkshire Hathaway, let's say you bought it 10 years. Why would you ever sell it? Unless you really needed the money or decided, "Hey, I'm 70 years old. I'm not going to live forever, and I want to go to Europe" or whatever it is. Maybe you could sell under those circumstances, but you should just be patient and let those great compounding vehicles work for you.
I think I would leave it at that, because that alone – actually, maybe there's one other thing. The other thing that I think that I don't hear enough – maybe people know this already, but I don't hear enough people say that saving, regularly setting money aside that you don't spend is the most important thing you'll ever do as an investor because that discipline sets you up for all the rest because you're foregoing current consumption. That is what investing is about. That's how you become patient. You don't spend your money. This seems obvious but I think people don't get it. The reason I think they don't get it is because they're in the market everyday trying to scalp a quick profit and they're getting murdered. People trading these zero days to expire options, and I know they're just getting fleeced by market makers. They're making rich people richer. They're not making themselves richer. The way you make yourself richer, the easy low-hanging fruit is to be a time arbitrager. Buy today, hold for the next 10 years, and you'll outperform a lot of people.
Corey McLaughlin: Yeah, that's great. Don't forget about your human capital and setting up automatic savings, I think, are two things that are very simple to do that will take the emotion out of things and maybe will help with the spending habit a little bit that we all are conditioned do to.
Dan Ferris: Yeah, what does being rich mean? It means you have a big pile of money you don't spend. It's like no matter how you look at it, savings is the essence of investing. It's the core of it. Well, that is another mailbag. I just can't tell you how much fun it's been. I hope we do 300 more of these you and I together, Corey. I know it'll be at least as much fun as I've had on these and just really looking forward to it. Thank you, everyone, for listening. The only reason we're sitting here yammering away like this is because of you, and we can't thank you enough.
Corey McLaughlin: Hear, hear.
Dan Ferris: Hear, hear. Yes. All right, now that we've celebrated our 300th episode with a wonderful look at the mailbag, let's go ahead and talk with our guest, Rob Arnott. It's his second appearance. I can't wait to hear what's on his mind. Let's do it right now.
I'm stepping forward with the biggest market warning I've ever made... bigger than when I called the Nasdaq crash in the fall of 2021, and bigger than when I predicted Lehman Brothers would collapse five months in advance. This is the clearest investment setup I've ever seen – a rare market event that's only occurred twice in 50 years. It's something most investors don't remember or are even aware of at all, and yet it has the potential to change everything. It'll impact merely every asset you own – your cash, stocks, bonds, even your real estate, and yet if you know what's happening and take the right steps today, you may never have to worry about money ever again. The last time we saw a setup like this, you could have made an incredible 1,000 times your money. To ensure you're among the first listeners to see my big prediction, head to www.dansbigwarning.com. Again, that's www.dansbigwarning.com to hear about the financial event heading your way right now.
All right, it's time for our interview once again. Today's guest is Rob Arnott. Rob Arnott is founder and chairman of the board of Research Affiliates. Rob plays an active role in the firm's research portfolio management, product innovation, business strategy, and client-facing activities. He is a member of the investment committee and the executive committee of the board. With Chris Brightman he is co-portfolio manager on the PIMCO All Asset Fund and All Asset All Authority funds and the PIMCO RAE funds. Over his career, Rob has endeavored to bridge the worlds of academic theorists and financial markets. I have to tell you that's one of the main reasons why I love the guy and why we're having him on the show. He challenges conventional wisdom and searches for solutions that add value to investors. He has pioneered several unconventional portfolio strategies that are now widely applied including tactical asset allocation, global tactical asset allocation, tax-advantaged equity management, and the fundamental-index approach to investing. His success in doing so has resulted in a reputation as one of the world's most provocative practitioners and respected financial analysts. Welcome once again, Rob Arnott.
Rob Arnott: It's a pleasure to be back.
Dan Ferris: Yes, and I was just telling you before we hit record here on the podcast that most of the folks who call us up and say, "Hey, I'd like to be on your show again" have something to sell, but when a very serious, highly respected guy like you contacts us and says, "Let's get me back on your show", it really gets me super excited. So, I went to – Rob, I went to your website and clicked on Insights where all your publicly available research is posted and I tried to figure out what might be on your mind. There are two pieces there from January with your name on them. One of them is called "Price-to-Fantasy Ratio: Self-deception with Forward Operating Earnings." The other one is "Revisiting Our 'Horrribly Wrong' Paper: That Was Then, This Is Now." It's about the paper in 2016 called "How Can Smart Beta Go Horribly Wrong?" Am I in the ballpark here as to what's on your mind?
Rob Arnott: There's that. We're also revisiting our old concept of RAFI. RAFI has fallen off a lot of people's radar screens in recent years because value was savaged for an entire decade. Here you have a strategy that beats value indexes. When value indexes are losing, it loses by less, or even ekes out a win when values' winning. So, if it wins against value when value's losing and when value's winning, that's pretty cool. So, we wrote a paper. I believe it's coming out in the next couple of days called "RAFI Rocks," in which we look back at the history and show that fundamental index wasn't just the inspiration for the term smart beta, but it's arguably the smartest smart beta strategy out there to this day after 20 years.
Dan Ferris: OK, I think we could probably do a lot with that intro. So, I'm a value guy. So, when you tell me that something performs better than value, the last decade notwithstanding, I get really interested. Just to let our listeners know, RAFI is Research Affiliate's fundamental index.
Rob Arnott: That's correct.
Dan Ferris: This is something that Rob and his team pioneered this whole approach. It's one of the things I mentioned when I was introducing Rob. They created it. We have the godfather of fundamental index here. Let's just do the simple parts of this for our listener. What's different about fundamental indexing versus some other kind of indexing? What other kind of indexing is there?
Rob Arnott: Almost everyone thinks of index funds as being capitalization weighted, and it makes total sense, because if you want to measure how the market's performing, the market is cap weighted. So, an index that's measuring the market ought to be cap weighted. If you want to match the market, as people who buy index funds do, it ought to be cap weighted. So, it makes total sense. Going back to the 1960s, the idea of indexing was reinforced by finance theory, first by Eugene Fama saying markets are efficient, and if markets are efficient, stock-picking is a waste of time... then by Bill Sharpe, who mathematically proved that if the market is efficient that you can't beat the cap-weighted market on a risk-adjusted basis. Of course, it makes a lot of heroic assumptions like markets are efficient, there's no taxes, there's no trading costs, you can leverage or deleverage at the same interest rate for all investors, and all investors have the same forward-looking expectation for returns on all assets. Apart from those simplifying assumptions, you could beat the market on a risk-adjusted basis.
So, the idea of fundamental index was, "Well, why do we want to weight stocks more heavily just because they're priced at lofty multiples? If a stock has doubled its weight in a conventional index doubles, why do you want to have more of your money committed to that stock after it doubled than before it doubled? It doesn't make a lot of sense." So, we thought, "Why index based on market cap? Why index proportional to share price so anything that's overpriced will be overweight? Why not just weight on stocks in a portfolio on the basis of the fundamental size of the business?" There's a lot of ways to do that. You could do weighting by company sales, or book value. When we tested this, the first time we tested it was almost exactly 20 years ago. We tested it on a sales-weighted index going back to the '70s, so about 30 years of data. We found that if you select the 500 largest stocks by sales, and weight it by sales, it outperforms the S&P by 2.5% a year for 30 years.
A lot of active managers would sell their grandmother to get 2.5% excess return for – but we then tested what if you do book-value weighting? What if you weight based on some smoothed average of company profits, or dividends? They all worked about the same – about 2% value add spanning decades. That's when it hit us. Why would it consistently add value? Because it breaks the link between the weight and the portfolio and the price of the stock. If a price doubles and the underlying fundamentals don't, fundamental index will say, "Oh, trim it." If a stock tanks and the fundamentals don't, fundamental index will say, "Thanks for the deep discount. I'm topping it back up" which means you get a rebalancing alpha. You're contra trading against the market's biggest bets. Some of those bets are correct, and in that case, the price is correct, and so you're not hurting yourself by rebalancing. Some of those market bets are incorrect and wind up reversing. So when you contra trade against the market's biggest bets, you're capturing a rebalancing alpha, but you're also creating a value tilt because the growth stocks are reweighted down to their economic footprint. The value stocks are reweighted up to their economic footprint and the result is that you have this stark value tilt.
So, we introduced the idea – there's currently about $140 billion run against fundamental index under – licensed from us. There's probably a similar number, a like amount, of imitating strategies. The idea is probably past the quarter-billion mark, but it's been sort of stalled the last few years for a very simple reason. The value sagged from 2007 to 2017 and then crashed from 2018 to '20, and so by summer of 2020 when the value hit its low point, you couldn't persuade anyone to invest in a value strategy. And yet, during that entire time, the Russell Value Index underperformed the market by 37% and fundamental index underperformed by 10%. During the subsequent rebound, Russell Value has outperformed the market by 10% and RAFI has outperformed by 22%. So, if you beat the Value Index by over 2,000 basis points on the way down, and over 1,000 basis points on the way up, you've got something that really is very special.
Dan Ferris: Yeah, robust too. As you're talking about this, I'm thinking about the way Buffett has given so much – Warren Buffett has given so much airtime to John Bogle and indexing and I thought, "Man, he owes Rob Arnott some airtime here." [laughter] You'd think as a value guy, originally anyway, that he would embrace something based on fundamental business performance is what we're really talking about here versus essentially momentum.
Rob Arnott: Yeah, I should give Buffett a call and set him straight.
Dan Ferris: You should [laughter].
Rob Arnott: Also Jack Bogle is credited with inventing index funds. That's not actually quite accurate. He invented the index mutual funds that the public can invest in. The originators of capitalization-weighted indexing for institutional investors was Dean LeBaron. Rex Sinquefield followed in short order. And these were the original pioneers. I'm not taking anything away from Jack Bogle. I think he revolutionized the asset management industry more than any other single individual in the 20th century.
Dan Ferris: Right, certainly approaches based on that idea have attracted at this point, what – trillions or well over a trillion.
Rob Arnott: Well, over $10 trillion is cap-weighted index. So, we're catching up. We have 2% market share in indexing. [laughter]
Dan Ferris: I mean given level of competition, that's pretty amazing. All right, so if one wanted to do this, is my only alternative to give Research Affiliates a call, and say, "Hey, I want to do fundamental indexing"? Are you the only place that this can be done? Or can I – is there an ETF?
Rob Arnott: We actually don't manage any assets. We license our ideas to others. So, Schwab and Invesco have fundamental index strategies. Quite inexpensive. Schwab's are in the quarter-percent-range TER. PIMCO licenses our fundamental index multi-factor and ESG strategies. For larger investors, there are comingled portfolios run by State Street using fundamental index. The idea can be accessed in lots of different places. We're heartened by the sharp uptick in flows into the strategy since the value turn. Schwab has added, not just from market appreciation, but from flows over $10 billion since the value cycle turned in the summer of 2020.
So, it's gratifying to see recognition and acceptance of the idea. Our business model is very unusual. We don't manage assets. We license our ideas to others, which imposes a high hurdle. Does Schwab need us? Does PIMCO need us? Does Invesco need us? No, they don't. They have their own R&D departments, their own product innovation teams, so the only way we get their attention is by bringing ideas to them that are complementary to their existing product offerings and that are high enough quality in design that they're happy to put their names on the concept. It's been gratifying to see global take-up of our ideas, not just fundamental index, but global tactical asset allocation and so forth.
Dan Ferris: I wonder if you could maybe drill down a little bit for us. Are the fundamental indexes – you talked about price to book and the other measures that you mentioned. Does RA have a single fundamental index that is based on a recipe of several of these metrics?
Rob Arnott: That's exactly right. FTSE, the big index company out of London, was the first to license the idea for redistribution to others. Invesco was their first client launching a FTSE/RAFI index fund in December of 2005 and to this day, that's now got longest track record of any fundamental index strategies. Russell embraced the idea, and Schwab bought it from Russell. Then FTSE bought Russell, so FTSE covers both bases and offers the fundamental index big asset managers to make available to their clients. Like I said, it's a very unusual business model. Others have tried it. You have to have good ideas and you can't be greedy. Typically, we get ballpark of 20% of TER, and if you're greedy and you say, "Oh, let's split it 50/50", pardon me. They're the ones doing the heavy lifting with bringing the clients in, with doing the back office, with trade reconciliation, with client reporting. They have to get the vast majority of the revenues, but the beauty is – I mean we only have 60 people. How many organizations with $160 billion in assets have 60 people?
Dan Ferris: It's nice. It's almost like a royalty company on assets. Yeah, I have a lot of appreciation for that. So, I did what I believe many of our listeners will do, Rob, as you're speaking. I typed RAFI into the little quote box on Yahoo Finance. I'm sure a lot of people do that, and what came up was three Invesco Funds: Invesco, FTSE, RAFI, U.S. 1,000, and then Invesco FTSE developed markets ex-U.S., then Invesco FTSE/RAFI emerging markets. Do the effects vary? The outperformance – does it vary based on U.S., ex-US, or emerging? Or is it some of that 2% you talk about?
Rob Arnott: It varies a little bit. Basically, remember we're getting a rebalancing alpha. You get a value alpha because of the value tilt, but the value alpha is unreliable, and value can go into periods of deep disappointment. For a long time, the worst ever was the tech bubble where value underperformed growth by 4,000 basis points in two years, just horrific. RAFI underperformed by 30% relative to growth, 15% relative to the market had it existed at the time. But then the snapback, you were back at a new all-time high within nine months after the bubble started to burst. The grandaddy of all value meltdowns was 2007 – 2020, if you use the classic Fama/French definition of value, which is price to book. Value peaked in March of 2007 and didn't hit bottom until August of 2020. Just absolute horror show for value investors. I've been a lifelong value investor. That was the toughest time in my career, but it was also a wonderful learning experience, far from dissuading me from value investing, it reinforced my confidence in it.
But back to the international side, if you're earning a rebalancing alpha, then you're making money by rebalancing against the market's mistakes. Jack Trainor, back in 2005, shows that if 90% of market movements are in the correct direction, the correct magnitude, and 10% are erroneous, that is to say the market makes an error and then subsequently corrects it, that 10% is enough to give you 150 basis points of value added from any strategy that breaks the link between price and the weight in the portfolio. You could use equal weighting. You could use darts. In fact, we replicated – we did a paper called "Upside Down Strategies – Malkiel, Monkeys, and Upside Down Strategies." Malkiel, in the last '60s, wrote a book, The Random Walk Down Wall Street, in which he suggested that a monkey throwing darts could do as good a job as the average active manager. He was wrong. The monkey throwing darts would win – would beat most active managers. We tested this by having a silicon chip monkey pick 30 stocks at random year by year, over the last 50 years, and we assumed that we had 1,000 monkeys. So, 1,000 different runs of 30 stocks a year. On average, the monkey portfolio beat the S&P by 160 basis points a year. So that's just from breaking the link with price. Fundamental index breaks the link with price but still keeps the link with the underlying fundamentals, meaning you're not loading up on little, tiny companies that are hard to trade. You're loading up on big businesses, which are usually large-cap stocks.
You're going to underweight the Teslas of the world and overweight the Chevrons of the world, because Chevron is out of favor, unloved, and relatively cheap, and Tesla's beloved, and frothy and expensive. You're going to downweight the Tesla and upweight the Chevron, but you'll still own both of them and you'll be earning money from the market's constantly changing opinion of what Tesla's worth or what Chevron's worth. Because it's weighted in accordance with the size of the business, and the size of the business doesn't change very much from year to year, the turnover is shockingly low. It's 10% to 15% turnover a year. That's all. So, your turnover is low. Your trading costs are low because you're mostly dealing with large, amply liquid stocks, and so this isn't the only way to break the link with price, but I would argue it's the best yet developed.
Dan Ferris: I'm sorry, Rob. Can you just clarify for me the turnover you describe – is this trading activity based on rebalancing or no?
Rob Arnott: Rebalancing and reconstitution. Now, the S&P 500 has 4% average turnover over the last 30 years. That's almost entirely dropping one stock and adding another. For us, dropping one stock and adding another is 2% or 3% instead of 4%, and rebalancing. Contra trading against market price movements is another 10% to 12%. So very low turnover.
Dan Ferris: Interesting. I'm wondering if we're weighting on the – we're talking about the fundamental size, the size of earnings, the size of revenues, etc. You do get these large – you mentioned Tesla. That's as reasonable an example as anything. Large-cap, big growers. I wonder if you get enough of those –
Rob Arnott: We've been underweight Google since the day of its IPO.
Dan Ferris: Really?
Rob Arnott: But for every Google, there's some little nitwit high-flyer that goes away, or a dozen of them. So, has Google helped RAFI's performance? Absolutely not. We've been underweight from day one. We're still underweight. Tesla – underweight from day one, still underweight.
Dan Ferris: Underweight versus market cap rate.
Rob Arnott: Right, but not underweight relative to the size of the business. So, I like to think of it as cap-weighted indexes mirror the look and composition of the stock market. RAFI mirrors the look and composition of the publicly traded macro economy. It's an economy-weighted index where cap-weighting is a market-weighted index. One thing that I think is a lot of fun is as human beings is we benefit from binocular vision. Two eyes means we can see 3D. What if instead of viewing the market from a cap-weight centric perspective, which simply says, "You're investing in stocks. Their size is efficiently determined by the market and that's a good representation of the future size of their business, or the market's best guess at that, which is an unbiased estimate and the market gets it right." Reciprocally and by the way, from that perspective, RAFI is an active-value-tilted strategy. There's another perspective. View it from the perspective of the macro economy and the market is making active bets. The market is saying, "Tesla is going to be way bigger than people think, way more important." Google is going to be massively successful, and Pets.com will just dominate the pet community." Some of these collapse, and some of these go on to great success.
The two big survivors from the first-generation tech bubble of 2000 were Apple and Microsoft, currently top two market cap stocks in the world. All right, Microsoft was big back in the year 2000 and was large cap. It was No. 1 back then. Apple was thought to be on the brink of failure and was floundering. Steve Jobs had come back. Nobody knew he could put it back on the right track and make it work. Now, it's a world-straddling colossus. But if you look at the top 10 tech stocks in the year 2000, how many of them beat the market over the next 10 years? Zero. How many beat the market over the next 20 years? One, Microsoft. What was the average performance over the subsequent 20 years for those 10 largest market cap stocks? Eight percent per year below the market. So, bubbles have consequences. Bubbles cost you a lot of money.
Dan Ferris: Yeah, bubbles and top dog effects.
Rob Arnott: Exactly.
Dan Ferris: What an insidious combination. It's the availability bias. It's all – any investor looking at the market sees these 10 and thinks, "That's the best. That's what I have to have. These are the no-brainer bets." I remember –
Rob Arnott: You can't get fired by buying IBM Computers [laughter].
Dan Ferris: Right. I remember Cisco was burned into my brain. It was in 10 of the top 10 mutual funds in 2000. It was the no-brainer. That was the internet plumbing. You couldn't go wrong. I don't think it's broken even yet.
Rob Arnott: Oh, it hasn't. It hasn't. I think its cumulative total return might now be positive, but its performance relative to the market is sharply negative. What's interesting there is their growth has been terrific. For the last 20 years, they've had earnings and sales growth of about 13% to 14% per annum compounded for 20 years. Wow! But the market was projecting 30%, so you project 30% and you get 13% and you think "Oh my god. This is a dog." It's only a dog relative to pricing it at 200 times earnings.
Dan Ferris: Right, and in 2000, RAFI would have weighted it teeny tiny if at all, if it was big enough.
Rob Arnott: It would have been big enough. It would have been big enough.
Dan Ferris: And then increased it as the business itself grew at this incredible rate.
Rob Arnott: But at the top of the tech bubble, Cisco had 22,000 employees. 22,000 employees is a lot of people, but it's not a lot of people by the standards of big businesses. There are companies with a million employees. So, it had 20,000 employees. It had let's call it two-basis-point market share out of the U.S. workforce. Or was it one basis point? Closer to one basis point, and it was 4% of the S&P.
Dan Ferris: When you put it that way, it just all seems so easy, doesn't it? [laughter]
Rob Arnott: Yeah, but the thing is contrarian investing, value investing, means buying what's unloved, what's out of favor, what people know are troubled companies and you will have some of those troubled companies turn out to amply justify their deep discounts and then some. Those are called value traps. Overly simplistic, you can say, "Stocks that look cheap on their way to zero." All right, you buy into those stocks, and you buy more and you buy more and then it goes bust. That's painful. The optics on that are terrible. People will say, "Obviously, the company was in awful condition." So, the 2009 trough of the global financial crisis in March of 2009, the FTSE/RAFI index which was the basis for the Invesco fund, the FTSE/RAFI index reweights back to the economic footprint of the company, and based on a blend of revenues, profits, book value, dividends.
Citi and BofA were both about 2% of the U.S. economy and General Motors was 1%. So, in the March rebalance, we top it up to 2%, 2%, and 1%. Meanwhile, the market had them around 0.2%, 0.2%, and 0.1%. I'm oversimplifying. I don't know that those numbers are exactly right, but anyway, we were massively overweight. We topped up. Lo and behold, GM went to zero, 60 days later. Citi and BofA tripled over the next six months. So, you had 2% positions tripling, one 1% position losing 100%, the optics are terrible, but the performance is brilliant.
Dan Ferris: Right, and frankly, a lot of folks I know who do manage assets, they report something that's an extreme example, and it's only three names – but they report something like that portfolio-wide over the longer time. Even Buffett in his latest letter, he points out the same thing. He says, "Most of my decisions are mediocre." I mean zero is less than mediocre, but still the point is there. It's just a matter of magnitude. Most of the decisions are mediocre, and yet, 15 or whatever it is big winners create a massive return overall.
Rob Arnott: Exactly right.
Dan Ferris: Right, and RAFI is good at that apparently.
Rob Arnott: Yeah, yeah.
Dan Ferris: But we have come, unfortunately, feels like five minutes, but it's been more like closer to 40. We have come to our final question, which is the same question for every guest, no matter what the topic, even if it's not finance, which we sometimes do. That question is – you answered it once before – that question is, if you could leave our readers with a single thought today, what might it be?
Rob Arnott: I should have anticipated the question having been asked in the past. I didn't. Outside of investing, and it can also apply in the investing world, think about what you can do that will make a difference. If you're a chef, come up with great dishes. If you're an investment manager, think outside the box. If you have the same ideas as everyone else, if you imitate others' ideas, you'll have assuredly average performance and average performance means you won't beat the market, and as an active investor, you'll have a period of three to five years of really lousy results and you'll find yourself out of business. Think outside the box. Whatever is your line of work or areas of interest, be curious and try to be the best that you can be.
Dan Ferris: Great. As you were talking, I was thinking I love what I heard and I've heard it from investors, and guitar-makers, and just entrepreneurs and all kinds of different people. So, it is great advice. All right, Rob. Thanks for being here. Thanks for calling us up and reminding us that we needed to have you back.
Rob Arnott: [laughter] Thank you for including me and as always, it was great fun.
Dan Ferris: All right, we'll talk to you again hopefully sooner rather than later.
Rob Arnott: All right.
Dan Ferris: Many mainstream analysts are predicting that stocks will recover soon, but I say we'll instead witness a cash frenzy unlike we've experienced in 21 years before stocks recover. I'm urging Americans not to buy a single stock until they see it. I predicted the Lehman Brothers crash in 2008, and I called the top of the Nasdaq in 2021, but this, this is the No. 1 most important thing to pay attention to for 2023. I'm not talking about another market crash or politics or inflation or any of these other things. As all this unfolds, the financial consequences of what I'm talking about could last for several decades. If you don't understand what's happening, there will be winners and losers, and now is the time to decide which one you'll be. This is why I strongly encourage you to read about my warning totally free today. It's all spelled out in a free report we've put together. Get the facts yourself. Go to www.stockdeadzone.com to get your free copy of this report. You can learn how to get my four steps to prepare for what's coming. Again, that's www.stockdeadzone for a free copy of this new report.
Well, I really enjoyed that for a couple reasons, not least of which is that it's Rob Arnott. Rob Arnott called us up and wanted to be on our podcast. It's like if Warren Buffett calls you up or something. It's pretty cool. And obviously, you heard once again, he's a sophisticated thinker who has really – he's innovated in the world of finance, and to say innovate in the world of finance, it's usually – it makes the – it really just gets my bullsh*t detector going, but with Rob, it's different. Because he is a value-oriented, fundamental-oriented type investor, so it makes all the sense in the world that one of his great innovations is the fundamental index. There are ETFs that you can buy that make use of that insight. Really, really cool stuff.
By the way, just Research Affiliate's website has all kinds of stuff that you can read and I encourage you to do so. I go there regularly myself. Man, great guest, and I can't wait to have him back. I hope he calls us up again soon. All right, well that's another interview and that's another episode of the Stansberry Investor Hour. I hope you enjoyed it as much as we did. We do provide a transcript for every episode. Just go to www.investorhour.com. Click on the episode you want, scroll all the way down, click on the word "transcript," and enjoy. If you liked this episode and know anybody else who might like it, tell them to check it out on their podcast app or at InvestorHour.com.
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