The Berkshire Special 2018

"Unlike in the past where EMs magnified US market swings, they face less downside risk now"

Research Affiliates’ Rob Arnott talks about bubbles, Smart Beta and the risk to the US market

Published 3 years ago on May 29, 2018 13 minutes Read
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Rob Arnott is not a typical manager who manages money for investors, instead the 63-year-old founder and CEO of the California-based Research Affiliates runs a research-heavy outfit that offers investment strategies to fund management firms and index providers. Advising over $160 billion in institutional investment assets, including the likes of Pimco, Invesco PowerShares, and Charles Schwab, Arnott’s tryst with finance began when his parents, both PhDs, bought him a stock when he turned nine. Arnott soon turned out to be a force to reckon with when he demonstrated why market cap-weighted indices made for a poor alternative to fundamental indexing, in what came to be known as ‘Smart Beta’. Arnott believes it’s not market cap but a blend of fundamental metrics such as sales, cash, book value and dividends that deliver value for investors. The avid collector of vintage bikes, who considers those models unique, believes that though the US is heading into a long-term bear market over the next five years, the downside risk for EMs is limited.

In an article you argued that we are in a bubble phase. Can you take us through the evidence to suggest that we are, indeed, in a bubble?

We just released a paper titled, Yes. It’s a Bubble. So What? I think the most important point of that paper was to offer a definition for what is a “bubble.” The term bubble is used by lots of people in lots of different circumstances. Everyone has their own thought about what constitutes a bubble. So, the first thing we did was to create a rigorous definition. That definition has two constituent parts. First, in order for something to be a bubble, it has to be very difficult to construct a set of expectations for future profit optimistic enough to deliver a positive risk premium relative to bonds or cash by using any reasonable projection of expected cash flows. The second part of the definition is equally important and that is to do with the marginal buyer. Investors in a bubble market are almost all momentum investors who like the “story” of the asset with little regard for the underlying fundamentals, willing to buy thinking they can sell the asset to someone else for a higher price tomorrow. 

Looking at today’s market using that rigorous definition, we see a lot of bubbles.


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