When it comes to investing in factor-based products, a little sin is in, said two analysts on opposing sides of the smart-beta debate.

In a much anticipated face-to-face discussion at the 2016 Morningstar Investment Conference in Chicago, Research Affiliates CEO Rob Arnott and AQR Capital co-founder Cliff Asness continued their ongoing debate over the usefulness of smart-beta products, but agreed that investing in factors like value, size and momentum work well when combined with a little market timing.

“We refer to timing the market as a sin, but we also recommend that investors sin a little,” Asness said.

Arnott reiterated the crux of a recent white paper that warned that some smart-beta strategies could go “horribly wrong” if investors buy into factors with high valuations.

“Check the price tag of what you’re buying,” Arnott said. “If you are buying a stock, ask what you’re paying for it … when you look at an asset class, you ask whether the asset class is relatively cheap compared to historic norms. When you look at smart beta, you should be asking the same question, ‘Is this strategy cheap compared to historic norms?’”

Asness agreed that some market timing when valuations were extraordinarily high or low was warranted, but said that investors would be more likely to benefit from diversifying across multiple factors.

“It’s important to distinguish cyclicality from randomness,” Asness said. “Sometimes a factor goes into favor, sometimes it goes out of favor, so investors have to be patient, too. Randomness leads to periods of underperformance because it just happens … its important to view these things in a portfolio context. I believe more in diversification than I do timing.”

Arnott pointed out that many of the most popular factors were discovered due to timing. For example, when the value effect was discovered in the late 1970s, it was following the collapse of the so-called “Nifty Fifty” large-capitalization growth stocks and a five-year period of relative outperformance by lower-value companies.

Similarly, the size factor was discovered in the early 1980s, when small-cap stocks were at historic highs in relative valuation.

Arnott and Asness disagreed on so-called low-beta factor strategies, with Asness saying that low-beta strategies help protect investors when the market peaks or enters a highly volatile period.

Arnott noted that the strategies often include large-capitalization, expensive companies -- like Facebook, Amazon and Netflix -- that violate his focus on valuations.

“People buy into these low-beta portfolios saying ‘Gee, this will help protect me from the market,’ but it may not,” Arnott said. “If it’s expensive, put a post-it note in your calendar and check back in 2018.”

Both men expressed doubts about the efficient market hypothesis. Asness, a student and teaching assistant for the hypothesis’s author, famed economist Eugene Fama, said that while markets are efficient over a very long time period, he believed that investors could take advantage of short-term inefficiencies in the market.

“My own view is a wishy-washy middling one,” said Asness. “Living through the tech bubble and the global financial crisis has moved me to the middle on market efficiency, I’m courageously in the center.”

Arnott, on the other hand, argued that it was likely impossible for market prices to reflect all available information at any given point of time.

Both men said that investors will be able to continue to exploit market inefficiencies through factor investing.

Theoretically, though, it’s easy to imagine more perfectly efficient markets -- an audience question posed the possibility of all investors turning to passive strategies in the future.

“If you went into a Ph.D. dorm of any finance program and saw what the students were smoking at 2 a.m., ultimately someone asks  ‘What if everybody indexed,’” Asness quipped. “There’s no great answer, and physicists might throw rotten tomatoes at me, but I would call that world a singularity. We don’t know what that world looks like, nobody is looking at prices in that scenario. I would think that buying Apple and shorting the corner drugstore seems like a good idea in practice, but Jack Bogle would argue with me, saying that ‘The average does not beat the average.’”

Arnott said that even with the rise of passive, index-based strategies, inefficiencies persist.

“The market is less efficient now than it has been over my career,” Arnott said. “It doesn’t make my job easier year by year, but it does make things easier on the long term. It’s easier to do well by trading against the lemmings.”