Rob Arnott: Don't Sleep on Value Investing (Especially Emerging-Markets Value)

Episode Summary

Executive Summary: Rob Arnott argues that today’s market leadership, especially in growth and mega-cap tech, resembles past bubbles and creates opportunity in cheap, unloved assets like value and emerging markets. He contends that valuation, not past performance, should drive portfolio decisions, and that contrarian, factor-aware investing can exploit recurring mispricings in markets and strategies.

Main Topics: Value investing and the long value cycle (Priority: 5/5): Arnott says value has suffered a historically extreme, prolonged underperformance but has become very cheap relative to growth, making it attractive on a forward-looking basis. Tech concentration and bubble parallels (Priority: 5/5): He draws strong parallels between current mega-cap tech concentration and the 2000 tech bubble, arguing that dominant stocks are often priced for perfection and vulnerable to disappointment. Indexing and fundamental indexation (Priority: 4/5): Arnott explains that cap-weighted indexing has an 'achilles heel' because it adds exposure to stocks as their prices rise, while fundamental indexing aims to counter that by avoiding price weighting. Risk premium vs fear premium (Priority: 4/5): He reframes expected returns as being driven less by risk premia in the classic sense and more by fear and crowding, which helps explain value, size, and mean reversion effects. Factor valuation and smart beta (Priority: 5/5): Arnott critiques popular factors like low volatility and many multi-factor products when they become expensive, arguing that factor returns depend on starting valuations and crowding. Contrarian investing and investor behavior (Priority: 4/5): He emphasizes that successful contrarian investing requires tolerating discomfort, avoiding performance chasing, and buying out-of-favor assets when narratives are most negative. Asset allocation, diversification, and return forecasting (Priority: 4/5): Arnott describes Research Affiliates’ free forecasting tools and says long-term returns should be estimated from yield, growth, and valuation change—not trailing returns.

Key Arguments: Value’s underperformance has been long, but the relative valuation gap has widened more than performance has deteriorated, implying value is cheap rather than broken. Mega-cap tech concentration resembles prior bubbles, where seemingly invincible leaders were priced for perfection and later underperformed or disappeared. Cap-weighted indexing systematically buys more of what has already risen, which can be a structural disadvantage when top holdings are expensive. Fundamental indexing outperforms over time by stripping share price from portfolio weights and avoiding concentration in overheated names. Market inefficiencies evolve: once a factor becomes crowded and popular, its expected return tends to fall; valuation matters for factors just as for stocks. Low-volatility strategies became expensive after heavy inflows and therefore look less attractive than cheap value strategies. Investors should favor what is unloved and cheap, but must be patient and scale in gradually because timing turns is difficult. Forecasting returns should rely on income yield, expected growth, and mean reversion in valuation multiples rather than recent performance. Contrarian success often requires enduring social and professional discomfort, especially near market peaks when diversification feels unrewarding.

Data Points: Value underperformance duration: 12 years - Arnott says the recent value slump rivals the tech bubble in duration and magnitude. Value vs growth revaluation upside - U.S.: Over 2,500 basis points - He estimates the gain if the growth/value spread merely returns to historical norms in the U.S. Value vs growth revaluation upside - emerging markets: Over 4,000 basis points - He estimates the gain if emerging markets value/growth spreads normalize. Fundamental index tracking error in 2007: 1.5% - He says fundamental index had a smaller-than-normal value tilt when value and growth were similarly priced. Normal tracking error for fundamental index: 4% - Arnott cites typical tracking error for the strategy. 2008 performance of plain vanilla Raffi: Underperformed by 3% - He notes the strategy lagged during the crisis before rebounding strongly. 2009 performance of plain vanilla Raffi: Outperformed by 15 percentage points - After the crisis, deep value exposure led to large outperformance. Top-dog stock underperformance: 5% per year compounded - Average 10-year underperformance of the #1 stock in a sector across eight developed economies. Global top dog underperformance: Over 1,000 basis points per annum - Average 10-year underperformance of the largest stock in the world. Top dogs studied: Eight global top dogs in 40 years - Arnott says only Microsoft had outperformed the market since becoming top dog. Expected long-run alpha from non-price-weighting: 1.5% to 2% per year - He says any strategy that ignores share price and market cap in weighting can add this much over long periods. Emerging market Schiller P/E: Below 10x earnings - He cites January 2016 as a very cheap point for emerging markets. Emerging market value P/E: About 7x earnings - Value stocks in emerging markets were exceptionally cheap in early 2016. Fundamental index in emerging markets P/E: Around 6x earnings - He notes how cheap the fundamentally weighted portfolio was versus global GDP exposure. Emerging markets return over 12 months: Over 80 percentage points - Raffi in emerging markets after the 2016 cheapness signal. U.S. stock yield: Just under 2% - Part of his long-term return estimate for U.S. equities. U.S. earnings/dividend real growth assumption: About 1% to 1.5% above inflation - Used in his return forecasting framework. U.S. real return estimate: About 0% to 0.25% over 10 years - After adjusting for yield, growth, and valuation mean reversion. Dollar-weighted vs time-weighted mutual fund return gap: About 2% per year - He cites Russ Kinnel’s 'Mind the Gap' research as evidence of investor timing mistakes. Low-volatility strategy inflows: Billions per month - He says heavy inflows in 2014-2016 made the factor expensive. Low-volatility underperformance after his warning: 800 to 1,000 basis points in six months - He says low-vol strategies fell sharply after the 2016 paper. Value outperformance after his warning: About 4% in six months - Following his call that value was cheap in 2016.

Pivotal Quotes: "If a style underperforms by a thousand basis points while getting cheaper by 2,000 basis points, that's a buy, not a sell." — Rob Arnott: Explaining why recent value underperformance does not necessarily mean value is unattractive. "Indexing does have an Achilles heel." — Rob Arnott: Arguing that cap-weighted portfolios mechanically add more exposure to rising, increasingly expensive stocks. "The notion is more of a fear premium." — Rob Arnott: Reframing expected returns as being driven by fear, crowding, and the desire not to miss out.

Implications: Listeners should focus on valuation and crowding, not recent performance, when evaluating stocks, factors, and funds. The discussion favors contrarian, patient, diversified investing and warns that popular, expensive themes may deliver weak future returns.