The world's biggest and best firms pay Rob Arnott for advice. He shared his top investing idea for the next 10 years - and gave us a peek inside his unique thought process.
- Rob Arnott, the chairman and chief executive of the Pimco subadviser Research Affiliates LLC, is a man whose expertise is so respected that multiple large firms license his investment ideas.
- In an exclusive interview with Business Insider, the industry legend revealed his big 10-year investing recommendation - one built around his groundbreaking quantitative analysis.
It's possible to reach the same conclusion as another person using an entirely different methodology.
That's simply the nature of investing. People follow the patterns and signals that look the most compelling to them, and it ultimately informs their decisions. Since there are only a certain number of outcomes, it makes sense that results will overlap.
It's also possible to apply flawed reasoning and still be correct, the same way it's possible to do exhaustive research and make the wrong call. In the end, the most informative approaches - at least over the long term - are those doing something unique, and those with proven track records. If that past performance can be explained, even better.
Rob Arnott - the chairman and chief executive of the Pimco subadviser Research Affiliates LLC - is doing his part to challenge set conventions and usher in an investing revolution. And he has the receipts to prove his approach is working. That makes him someone well worth listening to.
For years, Arnott has spread the gospel of an investment strategy known as "smart beta," which has evolved into one of the world's hottest investment strategies. The backbone of smart beta is a technique he's pioneered called "fundamental indexation," which is a practice that involves buying high and selling low, then using that rebalancing as a source of alpha.
After that, any time the link between the price of a stock and its index weighting is broken, the strategy sells on strength and buys on weakness.
In backtesting various smart beta strategies, Arnott found that employing this technique while anchoring an index based on any number of factors - such as sales and book value - beat benchmarks by roughly 250 basis points going back 30 years.
At this point, the world's biggest and best investors have caught on - and they clearly like what they see.
While Research Affiliates doesn't directly manage assets, it provides those firms with ideas. And the list of Arnott's licensees is a who's who of the investment elite - Invesco, Charles Schwab, and, of course, Pimco. In total, they oversee more than $200 billion using fundamental indexes maintained by Research Affiliates.
Now, with all that established, the multi-billion-dollar question remains: What's the best move for investors in the long run? Arnott is unequivocal in his response. He thinks traders should load up on emerging market equities.
Upon first glance, that may not seem like the most outlandish thought. After all, everyone from investing legend Jeremy Grantham to INTL FCStone strategist Vincent Deluard have reached similar conclusions.
It's how Arnott arrived at this recommendation that's particularly interesting. His two-pronged rationale is outlined in detail below. And, as you'll note, Arnott's thought processes are driven by the quantitative principles he's been developing for decades - the ones top firms pay big bucks to learn about.
1) Limited expected macro exposure over the long term + low valuations
Arnott doesn't understand why any long-term investors would concern themselves with the daily trials and tribulations of the US-China trade war. The way he sees it, if it's not going to have any sort of long-standing effect on markets over the next decade, it's not worth thinking about.
As a result, any associated price fluctuations create opportunities and market dislocations for investors to exploit. And the trade war is just one example. Arnott says this mentality should apply to any macro catalyst that's capturing headlines, but may not matter in the grand scope of things.
"Whatever people are focusing on today, it's really useful to ask whether it's going to have any lasting impact that will matter 10 years from now," Arnott told Business Insider by phone. "If not, whatever turbulence is caused by whatever folks are focusing on is actually something to contra-trade against. It creates volatility that you can turn into profit."
So how does EM fit into this discussion? For one, it's the area of the market that's been most negatively impacted by the trade war. If those steep losses are overdone at all, Arnott argues EM will snap back into its historical equilibrium, which means a bullish recovery from current levels.
"For emerging markets, that says buy, because they're in the bottom quintile of historic valuations," Arnott said. "If they stay right where they are, they're going to have a perfectly reasonable long-term return. And if there's any mean reversion, they're going to have wonderful returns."
He continued: "Right now, that would all point in the direction of watching out for the US, and an 80%/20% likelihood of EM beating US stocks over the next 10 years."
2) Demographic shifts
Arnott's point here boils down to one core tenet: A person's productivity peaks during their young professional years, between the ages of 20 and 40. As such, he concludes that gross domestic product growth is a function of the young-adult population, and how much time those people have been given to mature.
However, when it comes to capital-market appreciation, Arnott says it's mostly driven by mature adults in the 45-to-65 age range. He argues that markets do best when the mature population is larger.
"High GDP - as in the US, Japan, and Europe - is more a function of mature adults, where the productivity growth has already happened," Arnott said. "You see a lot of gray hair in the wealthiest countries."
He continued: "When it comes to capital markets, young adults don't have enough money to move markets."
Then, once mature adults decide to retire, their productivity dries up entirely. That means there's ultimately a middle-aged sweet spot during which certain geographical markets outperform.
As Arnott notes, developed economies like the US are in that fruitful zone right now. But he argues that once that generation ages further and eventually retires, it's the areas with the highest percentage of people hitting mature adulthood that will thrive. That means EM.
"They have hoards of people in their 20s and 30s who will age," Arnott said. "They'll go from being huge growth engines for GDP to being engines for capital-markets valuation. There's yet another reason for an emerging markets focus."