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.”