Both Arnott and Davidow believe that value-based strategies are poised to outperform,
“We had picked up on the valuation issue, too,” Davidow says. “Fundamental indexing is poised to do well, we have believed that the market would shift from momentum to fair valuation, and we’ve been seeing that change over time.”
The best bet in the near-term? Emerging-market value, according to Arnott.
“The reality is that current emerging markets are cheap,” Arnott said. “They’re so cheap that value strategies should be growing by 10 to 20 percent per annum over the next five years. That’s why we’ve been pounding the table on fundamental indexing the emerging markets and deep value in emerging markets.”
Davidow says that value’s recent underperformance is coming to an end.
“Last year was rough on the value factor and the fundamental indexing strategy,” Davidow says. “The beauty is that they don’t change what they do, over the long run you’d expect to see the returns from the value premium. There will be periods that they lag, and then you’ll see a dramatic snapback.”
Arnott said that advisors and investors should consider the relative valuation of a factor or strategy before adopting it based on historical performance.
Investors should first consider whether the proposed strategy makes sense, Davidow says.
“I think you have to start with looking at how strategies are poised to perform in a market environment,” he says. “Then we can look at today’s environment and use relative valuation to determine which strategy is likely to do better going forward. It’s a good complementary metric.”
Using Arnott’s measure, factors like low-volatility and quality have enjoyed good performance in recent years due to a rise in relative valuation, not because the factor has a significant impact on returns.