“Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive,” he wrote in the February treatise. “Is the financial engineering community at risk of encouraging performance chasing, under the rubric of smart beta? If so, then smart beta is, well, not very smart.”
Arnott was an early proponent when he developed fundamental indexing, which deploys criteria such as book value, cash flow and sales to select undervalued shares. Asness earned his doctorate in finance at the University of Chicago, studying under Eugene Fama, the godfather of the factor-based theory of investment, and adheres to a similar kind of approach today. While he’s often associated with momentum, the style that buys stocks that have been rising and sells those that are falling, he’s also a proponent of value smart beta.
‘Histrionic Comparisons’
Asness’s paper raises several technical objections to Arnott’s methodology, such as the use of long-horizon regressions for portfolios with high turnover, and says Arnott’s conclusions are convoluted and without merit. Not only that, he claims his peer is being deliberately alarmist, veering into “histrionic comparisons” to the technology bubble and the “quant crisis” of 2007 to scare investors. Ultimately, Asness says, trying to time factor strategies using valuations is just another form of the value style.
Arnott, in response, agrees it’s dangerous to aggressively buy factors that are trading cheaply and shun those that aren’t. Still, he says valuations can be used to adjust portfolios in a moderate way. What he’s cautioning about is the opposite kind of factor timing, piling into popular strategies, he says.
“It’s dangerous to ignore relative valuation outright, and to go ahead and load up on a factor just because its past performance has been brilliant,” the 61-year-old Arnott said in a phone interview. “Performance chasing is even more dangerous than the factor timing that he’s warning against.”
Factor Crash
One point on which both investors agree is that a sharp downturn in smart-beta strategies is probably coming. Asness says he’s more “matter-of-fact” about this, not because he’s playing down its impact but because such crashes are inevitable and impossible to predict. Valuations, he said, didn’t foretell the period in August 2007 when many quantitative hedge funds posted large losses at the same time.
“I see this as an unfortunate pain we must bear in exchange for the long-term positives of good factors,” Asness wrote. “Again I make the analogy to knowing that the stock market will one day suffer a short painful ‘crash’ does not mean one doesn’t invest in stocks for the long run.”
Other Reactions
Predicting the success of smart-beta ETFs based on valuations can be misleading, Jay Jacobs, director of research of Global X Management Co., said in March in reaction to Arnott’s paper. They can rise for factors such as low volatility or quality if people fear a market selloff and the higher levels won’t make them worse to own, he said. Alex Matturri, chief executive officer of S&P Dow Jones Indices, said many investors don’t expect smart-beta products to win all the time, and often use them for other purposes including hedging.
Asness’s prescription is to choose factors you believe in and stick with them over the longer term while expecting some difficult times along the way. The only exception is if valuations reach unprecedented levels, and we’re not there today, he says.
“Frankly, I think ominous-sounding references to the August 2007 event when valuations didn’t predict that event and are not at bubble extremes today (in either direction) amount to scare tactics essentially shouting fire in a surprisingly uncrowded factor theater,” Asness wrote.