The Death of Diversification (and Value Too) with Rob Arnott







Founder and chairman of the board of Research Affiliates, Rob Arnott, is deeply dedicated to the role of research in understanding and forecasting market trends. His commitment to research spans several decades, and he has published three books and more than 130 articles on various financial topics and earned several awards for his efforts, including seven Graham and Dodd Scrolls and four Bernstein Fabozzi/Jacob Levy awards.

In this episode, Greg and Rob sit down to talk about the fate of diversification (and value), how investors can appropriately size in a volatile market, whether or not smart money has gotten dumb, and why an investor should always seek to be curious. They also discuss key takeaways from Rob’s recent research and his capital market assumptions. Rob shares many important lessons in this episode and answers, once and for all, the question of whether or not diversification and value are “dead.”


0:00 Intro

0:30 Episode Overview

1:16 Welcome and Introduction

2:45 Institutional Investors vs. Individual Investors: Has Smart Money Gotten Dumb?

6:01 Is Diversification Dead?

10:57 2010s and Diversification: A Bad Deal

13:41 Is Value Dead?

21:11 Sizing Value When it's Underperforming

24:14 Timing Investment Factors

32:34 Important Lessons for Investing and Life

37:10 Thoughts on Cryptocurrencies

38:39 Rob's Hobbies: Motorcycles, Wine, and Travel


Rob Arnott

Founder and Chairman of the Board, Research Affiliates

Rob Arnott is the founder and chairman of the board of Research Affiliates, a global asset manager dedicated to profoundly impacting the global investment community through its insights and products. Rob plays an active role in the firm’s research, portfolio management, product innovation, business strategy and client facing activities. Over his career, Rob has endeavored to bridge the worlds of academic theorists and financial markets, challenging conventional wisdom and searching for solutions that add value for investors. He has pioneered several unconventional portfolio strategies that are now widely applied, including tactical asset allocation, global tactical asset allocation, tax-advantaged equity management, and the Fundamental Index™ approach to investing. His success in doing so has resulted in a reputation as one of the world’s most provocative practitioners and respected financial analysts. In 2002, Rob founded Research Affiliates. Rob served as chairman and CEO from 2002 to 2018. Prior to establishing Research Affiliates, Rob managed two asset management firms. As chairman of First Quadrant, LP, he built up the former internal money manager for Crum & Forster into a highly regarded quantitative asset management firm. He also was global equity strategist at Salomon Brothers (now part of Citigroup), the founding president and CEO of TSA Capital Management (now part of Analytic Investors, LLC), and a vice president at The Boston Company. Rob has published more than 130 articles in such journals as the Journal of Portfolio Management, Harvard Business Review, and Financial Analysts Journal, where he also served as editor in chief from 2002 through 2006. In recognition of his achievements as a financial writer, Rob has received seven Graham and Dodd Scrolls, awarded annually by CFA Institute to the top Financial Analysts Journal articles of the year. He also has received four Bernstein Fabozzi/Jacobs Levy awards from the Journal of Portfolio Management. He is co-author of The Fundamental Index: A Better Way to Invest (Wiley 2008). Rob Arnott received a BS summa cum laude in economics, applied mathematics, and computer science from the University of California, Santa Barbara.


Greg Dowling

Chief Investment Officer, Head of Research, FEG

Greg Dowling is Chief Investment Officer and Head of Research at FEG. Greg joined FEG in 2004 and focuses on managing the day-to-day activities of the Research department. Greg chairs the Firm’s Investment Policy Committee, which approves all manager recommendations and provides oversight on strategic asset allocations and capital market assumptions. He also is a member of the firm’s Leadership Team and Risk Committee.


Greg Dowling (00:06):

Welcome to the FEG Insight Bridge. This is Greg Dowling, head of research and CIO at FEG. This show spans global markets and institutional investments through conversations with some of the world's leading investment, economic, and philanthropic minds to provide insight on how institutional investors can survive and even thrive in the world of markets and finance.

Greg Dowling (00:30):

Some have declared the death of diversification--and value too. Is that announcement premature, or is there life after death? Today we're happy to host Rob Arnott. He has dedicated most of his professional life to investment research. He is the founder and chairman of Research Affiliates. He has published three books and written more than 130 articles in journals such as the Harvard Business Review, the Journal of Portfolio Management, and the Financial Analyst Journal, where he also served as the editor-in-chief from 2002 to 2006. Rob has also won more awards for his research articles than I have time to mention. Bottom line, Rob is a super-smart guy and the right person to tackle these difficult questions on death.

Greg Dowling (01:16):

Rob, welcome to the FEG Insight Bridge.

Rob Arnott (01:19):

It's a real pleasure to work with you guys over the years. I'm delighted to participate.

Greg Dowling (01:24):

Would you mind introducing yourself and Research Affiliates? It's not the typical asset management firm.

Rob Arnott (01:30):

Sure, absolutely. When I launched Research Affiliates, I was also running a company called First Quadrant. To avoid conflicts of interest, I decided to put Research Affiliates on a path of designing and developing product ideas, licensing them to others, giving Research Affiliates first shot at those ideas, and not running money to avoid conflicts of interest. It turns out that model actually works pretty well, so we've stuck with that model. We're probably the only $170 billion asset manager that manages no assets. We do so by offering our best thinking through distribution partners, PIMCO is the largest, Schwab is a close second, and there's Invesco, SSGA, BlackRock, Legal & General--all in the $10 billion plus range. Basically, we partner with organizations that have really a powerful distribution engine. They can view us as an extension of their product R&D and we can view them as our distribution arm.

Greg Dowling (02:38):

Well, I think you've definitely set the bar for research and spent a lot of time on research, so this is a great question for you. Institutional investors, I think most would agree, have the scale and resource advantage over individual investors, yet many retail investors--just buying a few FANGs and maybe now meme stocks, and for diversification purposes maybe they're throwing in a few crypto assets--have beaten the pants off institutional investors. Has smart money gotten dumb?

Rob Arnott (03:09):

Well, it's funny the way you frame that question. My son, who's in his mid-30s, came to me about 18 months ago and asked my investment advice. I said, "You're in a technology field, you need to diversify away from tech. Your entire book of business is in the U.S., you need to diversify outside the U.S. So I would suggest broad diversification in asset classes other than stocks, largely with a non-U.S. focus." And he said, "Great, that's interesting. I like Tesla and Bitcoin, what do you think about them?" I said, "Well, I think they're bubbles, but bubbles can go further and last longer than any skeptic could ever imagine, so if you want to put some money into those, go for it, just don't put money you aren't fully prepared to lose." And he said, "Thanks." Three months later, he got back to me and said, "I put it 50/50 in Tesla and Bitcoin." And in January he sent me his investment statement and said, "I was up 382% last year. How'd you do, dad?" I said, "You know, I'm really pleased. I was up 12."

Greg Dowling (04:10):


Rob Arnott (04:14):

[laughs] So yes, the smart money may have gotten dumb or a little behind the curve, but bubbles do last longer and go further than anyone could possibly imagine. We did a series of papers back, I think in 2011, called "Clairvoyant Value," where you value companies based on their future cash flow. Take the actual future cash flow and find out what the company would have been worth back in, let's say, 1983, and then ask the question: "How was it priced?" Now, that work suggested that if you had perfect clairvoyance on the future value of an investment--not its year-by-year results, but the IRR of all future distributions--you would add 6% a year. It's not as much as most people think. What was fascinating about that work is that that 6% was in a wide range from +20 to -5 or -6. So there are years when, if you have perfect clairvoyance, you would lose money relative to the market. 1999 was a vivid example of that. I suspect 2020 will go down as another vivid example of that. Having some guiding principles on how you invest I think has a great deal of merit, but you have to stick with those guiding principles, you can't try to chase every fad that comes along.

Greg Dowling (05:36):

I love the story you shared about your son saying, "Hey dad, how did you do?"

Rob Arnott (05:41):

Oh, it was so funny.

Greg Dowling (05:43):

That's how many of us feel in the investment industry these days. Whether it's your father-in-law, your brother, or a cousin, it seems like everybody's doing a little bit better by buying AMC and GameStop and whatever current fad there is. I've read that paper. That is a great paper. A recent paper that you've done earlier this year was called, "Is Diversification Dead?" You did research over a long period of time. What did you find?

Rob Arnott (06:11):

Well, we went back over 45 years from 1975 through 2020. During those 45 years, diversifiers, one of the asset classes that typically don't make their way, in size, into a portfolio--some obvious inflation hedges like commodities, REITs, and TIPs, some out-of-mainstream assets like high-yield bonds, emerging market stocks, and emerging markets bonds--hardly any of these make it into most investors' portfolios at a scale larger than about 5%. If you looked at the performance of a 16-asset class portfolio that invested across what we call first pillar, mainstream stocks, second pillar, mainstream bonds, and these diversifiers, we found that the performance was better and the risk lower over the last 45 years. Even though this 45-year span, if you think about it, started at a point of peak bond yields--not the highest ever, but certainly very high bond yields--so that we had a stupendous bond bull market during most of that 45 years and a stupendous stock market bull market.

Rob Arnott (07:17):

So 60/40, classic, balanced investing, enjoyed massive bull markets in both of their primary asset classes. And the diversifiers helped push the returns higher. Imagine how the diversifiers will work in market conditions that don't have a stupendous bull market in mainstream stocks and bonds. Basically what we found is that diversifiers tend to be steady-eddie. They tend to produce fairly reasonable returns most of the time. In the 2010s, they produced low single-digit returns. Well, that's very frustrating and it makes it feel like every penny put into diversifiers was a complete waste of that money. Well, it did incur an opportunity cost, but past is not prologue. The 1990s looked very similar to that. What did the 2000s deliver? They delivered vastly lower returns for 60/40 than the 1990s and the diversifiers produced roughly the same returns as in the 1990s. Very interesting to see the diversifiers chug along and stocks give you wonderful returns in the 90s, horrid returns in the 2000s. I think the 2020s are much more likely to resemble the 2000s than to repeat the 2010s.

Greg Dowling (08:33):

Why 45 years? Was that just based on the relevant data you needed and some of the benchmark didn't go back?

Rob Arnott (08:40):

That's exactly right. Go back before 1975 and there really weren't liquid markets for asset classes much outside of mainstream stocks and bonds unless you went into illiquid private companies and things like that. But in liquid markets, you really only had the two pillars.

Greg Dowling (08:58):

What about weighting? Could somebody say, "Well, look, it's kind of data mining and you're equally weighting." If most investors aren't equally weighted, if you used a more logical weighting, what would the results be?

Rob Arnott (09:09):

Well firstly, no matter what weighting scheme you choose, if you rebalanced back to that weight, you're adding a rebalancing alpha. What's a rebalancing alpha? The market has a tendency to overshoot. So if stocks soar, we all view it as perfectly natural to trim our stocks and top up other asset classes. Why don't we do that within the stock market? A cap-weighted index fund doesn't do that. If GameStop rises 100-fold, as it did, a cap-weighted index fund will say, "Oh yeah, this is fine at $350 just as it was fine at $3.50." Rebalancing can be applied to a whole host of asset classes. And actually, the more asset classes you use, the more rebalancing adds. We did a paper back in around the year 2000 in which we looked at rebalancing with two asset classes--stocks and bonds--and on a risk-adjusted basis, you get about 30 to 40 basis points extra. Do it across a dozen asset classes and you start getting 100 basis points extra, it really starts to matter.

Rob Arnott (10:11):

So the equal weighting is, in a sense, actually a source of incremental return. Unfortunately it goes against human nature, because whatever is newly expensive is more heavily weighted in our portfolios, typically. It got there by dent of creating great joy and profit, and so we're loathe to trim it. Anything that's newly cheap got there by inflicting pain and losses, so we're loathe to top it back up. But a simple rebalancing discipline can be a useful discipline for adding tens of basis points, which doesn't sound like much, but boy, it accumulates over time, tens of basis points to our return over long periods of time.

Greg Dowling (10:50):

It sure does, yes. Compounding is one of the amazing things that we have to play as long-term investors. One of the takeaways from your paper, for me at least, was how bad the 2010s were for diversification. So what made that decade so bad for diversification?

Rob Arnott (11:09):

What made it so bad for diversification was a stupendous bull market when he measures the second biggest equity bull market ever, which meant that any departures from plain old S&P were very painful. Hardly any asset classes remotely kept pace. Now the diversifiers also had a little bit of a problem in that in 2013... As you know, we run PIMCO's All Asset strategies. And in 2013, we had $2 billion a month pouring in. It was pretty wild. We did a road show and I was basically saying, "Look, mainstream stocks are fully priced, mainstream bonds have terrible yields, and the diversifying markets are fully priced. So we're hunkered down with a risk-off posture waiting for some of these third pillar markets to get cheap, and they will." And of course, that's what happened. But when we pound the table, saying in early 2016 or late 2020, "The diversifiers are now cheap," that doesn't trigger money flowing in. It's the nature of the business.

Greg Dowling (12:23):

The 2010s were such a unique period. It felt like one really long economic cycle. We didn't have one bear market in that 10 years.

Rob Arnott (12:32):

Or recession.

Greg Dowling (12:33):

Or recession. I mean, that's pretty unique for just about any other 10-year period in history. Is there other comparables that you could look at--either from how long that cycle went or just the way the bull market went against diversification?

Rob Arnott (12:47):

There are other examples, but not quite uninterrupted. If you look at 1948 through 1965, you had basically a non-stop bull market interrupted by a couple of minor bear markets, nothing major until '66. It's not without precedent. We also had the bull market from 1982 to 2000, interrupted by a crash in '87, minor bear market in '90 and '94--that could be viewed as an 18-year bull market. The current one could be viewed as a 12-year bull market and counting, if you set aside that little episode of the COVID crash, which rebounded and hit new highs in shockingly short order.

Greg Dowling (13:34):

So diversification had a pretty long losing streak.

Rob Arnott (13:38):

Losing in relative terms.

Greg Dowling (13:41):

It had a "losing streak" in air quotes. And if you defined value in sort of the classic Fama French terms, HML, it also had a pretty long losing streak. So you talked about diversification maybe being dead, is value dead?

Rob Arnott (13:57):

Given that our business largely hinges on value investing and third pillar investing, I'd have to say the last few years were the most challenging in my entire career, bar none. And yet, we still wound up with a very solid book of business. And I think that has to do with helping people understand the merits of diversification on a long-term basis and the merits of value on a long-term basis. We wrote a paper in the first quarter issue of the Financial Analyst Journal this year, entitled "Reports of Value's Death Have Been Greatly Exaggerated." It's kind of a takeoff on mark Twain's famous comment. He went to San Francisco for a speaking engagement and arrived to see newspaper reports of his death. And he opened his remarks by saying, "Reports of my death have been greatly exaggerated."

Rob Arnott (14:46):

But anyway, we looked at the narratives for why value is now suddenly dead. A lot of them were what I would call "now-casting," which is forecasting the future by describing what recently happened in the past. It sounds intelligent, you remember it as prescient because they were describing what already happened and your mind does a time shift imagining that they've been saying it all along. But in point of fact, the narratives for value's death were in a new economy. The new economy has far more reliance on human capital and intellectual property, so classic metrics of value are useless. Interest rates are low, and with low interest rates, growth stocks with their future growth--10 and 20 years out--being discounted at a very low rate, that growth is suddenly more valuable than it would be in a higher interest rate environment, and so forth. So we looked at each of these narratives and we found most of them wanting.

Rob Arnott (15:48):

The narrative that it's a new economy has merit, particularly as it relates to the Fama French HML factor, because that's based on book-to-price. And if book value is grossly understated for a lot of companies, then the book-to-price looks very low when it might not be. So one part of the paper focused on the classic narratives and showed that they are flawed, the other part focused on book-to-price and showed that book value is a terrible measure. Basically, if I invest, if I spend $1,000 on a desk, my company's book value goes up $1,000. If I spend $1,000,000 on R&D, that's just money pissed away, as far as book value is concerned. Well I wouldn't put the million into R&D unless I thought I was going to get it back. So if you take that as your premise and you say, "Okay, it's an intangible asset, let's add it to the balance sheet."

Rob Arnott (16:47):

And just like a desk depreciates, gets tired-looking and old, the research depreciates. So you write it off over, let's say, the next 10 years. Now, if you do that, book value is topped up by R&D, which amortizes out, and new R&D tops it up again. What you find is that in the United States, on average, intangible book value is approximately equal in size for the average company as tangible book value. For some of the growth stocks, it's 3 to 5 times as large. For some stodgy, old industries, it's a 5th or a 10th as large. But if you adjust book value for intangibles, what you find is that a price-to-book-based approach to defining value works roughly twice as well. Over the last 60 years, the HML value portfolio beats the HML growth portfolio by a factor of 4. Adjust for intangibles and it wins by a factor of 8. So that's kind of interesting.

Rob Arnott (17:51):

The other part of that paper looked at the basic underpinnings of the meltdown in value. As you say, HML has underperformed since 2007. Adjusted for intangibles, it's underperformed since 2014. Well, that's a lot better. If you use price-to-sales ratios, it's underperformed since 2017. That's a heck of a lot better. If you use RAFI or RAE to define value, it's underperformed since 2017. That's a much milder hit than going all the way back to 2007. So it largely depends on how you define value. But no matter how you define value, those 4 years--2017 through 2020--were miserable. Very tough time to be a value investor. Now here's where it gets interesting. Value underperformed growth by 58% between 2007 and summer of 2020--that's using price-to-book value, classic HML--but it got cheaper by 68%.

Rob Arnott (18:54):

Now, what do I mean by cheaper? If it's underperformed, of course it got cheaper. No, I mean, it got cheaper in relative valuation multiples. Back in 2007, the price-to-book value of the Farma French value portfolio was 1/4 that of the growth portfolio. Sounds like a big spread, it's not. Normal spread is 5 to 1. It got to 10 to 1 at the peak of the tech bubble. Growth stocks got extravagantly expensive, value stocks were deeply out of favor. And by the summer of 2020, it was 0.08 times as expensive as growth, meaning growth was 12.5 times as expensive as value. And that spread was, by 25%, the largest in history. Imagine you have a stock that falls 58% and its price-to-book value falls 68%, meaning that its book value has chugged ahead, it's gotten bigger and bigger.

Rob Arnott (19:48):

Do you look at that and say, "I can't stand the pain, get me out of here"? Or do you look at that and say, "I can't believe how cheap this is. If I can possibly persuade my clients to top up and to put money back into value, or even over-rebalance, take on a value tilt that's larger than historic norms, then I'm doing them a huge favor because this thing is remarkably cheap." Well, that's the case we were making last summer, and it actually remains true today. The rebound in value relative to growth has been well over 2000 basis points. Relative to the market, well over 1000 basis points. And yet, if you look at the graph, the graph shows performance falling off a cliff. The rebound since last August is a tiny uptick. It's small relative to what happened to value. So we think this has a long way to run. The peak of the tech bubble was followed by 7 years in which value beat growth by well over 10,000 basis points. Well over 100 percentage points.

Greg Dowling (20:54):

How should investors think about that? It seems like the value factor... Well, no factor is linear, it doesn't produce returns like, "Hey, value might outperform over the long term, but has periods, even decades, of underperformance."

Rob Arnott (21:10):


Greg Dowling (21:10):

You certainly want to tilt your book to things that perform over time, but if you tilt your book too far-- from a behavioral standpoint, and also if you're a wealth advisor, you're a consultant, you are going to get fired in three to five years...

Rob Arnott (21:26):


Greg Dowling (21:26):

How do you size these things? How do you keep yourself in business when value underperforms for over a decade?

Rob Arnott (21:34):

You know, part of that is educating the clients, making sure they understand what's happening and why. And part of that is, exactly as you say, sizing. The very simple rule of thumb is never, with other people's money, make a bet larger than they would likely tolerate 2 awful years in a row. And if you are sizing it larger than that... For some nervous Nellies that means don't make any bets, just index the whole darn thing. For clients with long horizon and enormous tolerance for residual risk, tracking error relative to their next door neighbor, or my tracking error relative to my son, you can make big bets. But for most people you can't. So if you make a 10 percentage point shift in mix in favor of something that is seriously out of favor, that's not likely to trigger severe anxiety, even if it's out of step for 2 years. But you're right, 5 years, 10 years, when things are out of favor for a long time, it does exceed client risk tolerance.

Rob Arnott (22:41):

One of the things that I think is fascinating is we all talk about risk tolerance as if it's tolerance for volatility. No, nobody cares about upside volatility. They talk about risk tolerance as if it's tolerance for downside volatility. Well, even that's a little too simplistic. If your portfolio for your client is down 20% and the market's down 40%, you're going to get a pass. The clients are going to be unhappy, but not unhappy with you. They're going to be grateful they were working with you. So what really counts, ironically, is how you're doing relative to your peer group, the Joneses next door, how they do. That matters far more in behavioral finance than simple volatility.

Greg Dowling (23:27):

I agree. And there's actually--I think in your paper you state an actual case study experiment that was conducted on salaries. You want to share that?

Rob Arnott (23:37):

What we find is that people do not care that much about their salary. They care about their salary relative to what they perceive as their peer group. Now that might be an international peer group. If you're an equity strategist for B of A, you care how you're doing relative to equity strategists for Barclays in London, or whatever. Very often, it's the person in the next office over. People tend to be happier if they're making less and their next door neighbor is making less also.

Greg Dowling (24:09):

I think that's absolutely right, Rob, in terms of your wise counsel on sizing. When it comes to factors, whether it's value or momentum growth, can you time the investment of these factors and know when to overweight or underweight them?

Rob Arnott (24:24):

The answer depends on your definition of timing. If to time a factor means picking when it will turn, the answer is categorically no. No one has access to that quality of crystal ball. But when it comes to knowing how to size your bets, when to increase your bets, the answer is yes. We wrote a paper in 2016 entitled "How Can Smart Beta Go Horribly Wrong?" It was massively controversial. We had competitors excoriating us for having the nerve to suggest that factors ebb and flow in a fashion that you could have predicted in advance, to some extent. I found the controversy itself kind of amusing. If a stock soars and its fundamentals don't, we know it's past return will look brilliant, and we know if there's any mean reversion its future returns will suffer. Saying exactly the same thing about factors and strategies was controversial.

Rob Arnott (25:23):

What? Why? So what we found was that just like you can value a stock using multiple measures of valuation--price-to-book, price-to-sales, and so forth--you can do the same thing with factors and strategies. I mentioned earlier the value factor. Normally the value portfolio is 1/5 the price-to-book of the growth portfolio. So when it gets to 1/10, that rubber band is really stretched. Now is the rubber band going to break? Not likely. There's always been growth and value, and there always will be growth and value. So to some extent, when it gets really stretched, you have very high odds--for the patient investor--of winning with a shift towards value. Do you know when the turn's going to happen? Can you time it? No. In fact, you are almost guaranteed that you'll miss the turn.

Rob Arnott (26:15):

Now, if you miss the turn, what does that mean? You shift into value and you look and feel like an idiot for a while. And people start to question the wisdom of your choices. If you are true to your principles, as it gets cheaper still, you gently rebalance in a little more, a little more. And that's the one way to assure that you have peak exposure when the turn happens. Now, one of the wonderful things about RAFI and RAE is that they do this automatically. If the spread between growth and value is narrow, we're going to reweight the growth stocks down a little to their economic footprint and the value stocks up a little to their economic footprint. So we'll introduce a little bit of a tilt. And if the spread between growth and value widens, we'll take on a big value tilt. So our value tilt is dynamic in exactly the right way--we take on a bigger value tilt when value is cheaper. This is why these strategies have so relentlessly beat all commerce in the value side of the market. Beating the value indexes, beating the value fund mediums. And not by a little bit, by a lot. So to the extent that it requires judgment to make these shifts, that's tough, and you will be challenged and questioned. To the extent that you can automate it, that's really cool, but you'll still be challenged.

Greg Dowling (27:41):

Great wisdom that you're providing to us. Maybe you can look in your crystal ball and help investors today. We know we can look to history and that can give us some capital market assumptions for the future. It seems to me that if you're just a plain vanilla, 60/40 investor, the returns over the next 5 to 10 years don't look very good. What is an asset allocator going to do? What is a client going to do to get to that spending rate or 6% return that most people hope for?

Rob Arnott (28:11):

For those who are listening to this Insight Bridge, many of you may know that we have an interactive website for asset allocation and an interactive website for smart beta. So if you just Google "asset allocation interactive" or "smart beta interactive," it'll take you straight to our website. What we do with that website is we try to encourage people to not focus on past returns, but future returns. Okay, how do we do that, because we don't know what the future returns are? Well we do on a long-term basis. On a short-term basis--what's the stock market going to return over the next 12 months?--I haven't a clue. What's it going to return over the next 10 years? Now we're talking about something where you can predict within reasonable error bounds. The yield for the stock market is 1.5%. The average yield in the last century was 4.5%. Ouch.

Rob Arnott (29:05):

The growth in earnings and dividends the last century was 1.5% above inflation. So CPI plus 1.5%. Maybe shade that a little bit because we're a more mature economy. Let's assume 1.25%. Add those two together and you've got yield plus growth, real growth, over and above inflation of a little under 3%. Add in inflation and you're probably at about 5%. Is 5% a great return? No. Is it a bad return in a zero-yield environment? No, it's fine. But current valuations are about 34 times the 10-year average earnings, it's called the Shiller PE ratio. The price relative to 10-year average earnings, 34 times. And the historic norm is 18 times. Well, if you mean revert, you're going to be losing 6.5% a year to reducing valuation multiples. That takes you into negative return territory.

Rob Arnott (30:04):

But what if we don't mean revert? What if this is a new normal? Thirty-four is now, for whatever reason, just fine. Then you get your 5%. Our assumption is we don't know which is right, so let's split the difference. That simple method--halfway mean reversion over 10 years, yield plus growth--if you go back over the last 50 years, it predicts the stock market's return with an average error of between 2% and 3% per year. Right now, today, it's saying: "Expect 2%." So that means you might get 5, you might get -1. Do I want to put a lot of my money into a market that's priced that way? No. Now value is sufficiently stretched that value should beat the market by 2% to 3% a year. That helps. The fundamental index is skewed more heavily towards value because value is so cheap. So that on our smart beta interactive website shows up as an expected excess return of 5% a year over the next 10 years.

Rob Arnott (31:06):

If you add that to the return, now you're looking at somewhere between 4% and 10%. Okay, well, U.S. value is not bad. If you do the same math for emerging markets, you get a range of approximately 7% to 15%. Well that is interesting. I have over half of my liquid net worth in emerging markets value, implemented by way of the PIMCO RAE strategy. And that's a good, solid rate of return. That's something I can sleep very well at night with half of my money in emerging markets, deep value, loathed, feared, and out of favor companies. And yes, my tracking error relative to my next door neighbor or my son is going to be huge

Greg Dowling (31:53):

What you're talking about isn't crazy, right? Because we don't have to go back that far. In the period after the tech bubble, we had a 10-year return of the S&P 500 of zero, right? So yes, over long periods of time, great returns, but it doesn't do it every year, or every 5 years, or every 10 years. There is cyclicality to all of this. So it's not that crazy that you're saying we might have flat returns or even slightly negative returns based on where we are from a valuation perspective.

Rob Arnott (32:23):

If you buy what's cheap and you're patient, you're going to do fine. If you buy what's expensive, hoping it will go higher, you may do fine short term. You won't do well long term.

Greg Dowling (32:33):

I've had the opportunity to attend some of your conferences over the years. I remember one cocktail kind of party after all of the different presentations where I'm literally sitting at a table having a drink with two Nobel laureates right next to me. You've had the opportunity to do this for years, who are some of the people that have influenced you the most? And is there any takeaways or wisdom that you can share with us?

Rob Arnott (33:00):

One takeaway would be: Figure out who you admire, spend time with them, and seek out and learn from mentors. They don't have to be Nobel laureates. Peter Bernstein didn't have a PhD--I suggested to Harvard that they might want to give him an honorary PhD because he got a bachelor's from them and was firmly rebuffed. In any event, no Nobel Prize, but vast curiosity. Albert Einstein was once asked, "What's the secret behind your creativity?" He said, "I have no special advantages other than unbounded curiosity." Bill Sharp, hugely curious. Harry Markowitz, the same thing. Vernon Smith, same thing. These guys are still alive. One of the takeaways is: be curious. Harry remarked to me once that one of the things that he finds fascinating is how many people in quantitative finance do research without ever looking at the outlier data points to try to understand what's happening there.

Rob Arnott (34:03):

They don't even look at the data points, they just look at the regression stats. He said, "There's a lot to learn from the individual extremes." What a great takeaway! Vernon Smith never bought into the efficient markets hypothesis--neither did Harry--and made a career out of running experiments where people are trading real money. It's not a lot of money, it's a few 10s of dollars. But doing it live on laptops integrated into a network, where the end-point value of the asset is known. And he found bubbles and crashes where people would be buying something above its end-point value plus all intervening dividends that they could expect, because things are on a run and you're going to sell to somebody still higher. And then when people realize the emperor has no clothes, you get, not a decline, but a break in the trading and a crash. So when you look at things like that, and you look at GameStop and you look at AMC and you look at Tesla, you wonder, "How can anyone believe the market is efficient?"

Greg Dowling (35:12):

One of those people I sat next to was Vernon.

Rob Arnott (35:15):

Oh, he's a wonderful man.

Greg Dowling (35:16):

And he's certainly done a lot to build into the whole game theory research. I know he's a huge fan of Adam Smith as well. Many of these people are still alive, but even the ones that aren't, you can go back and pick those books up and there's a lot of great stuff in there.

Rob Arnott (35:32):

Yeah. Vernon is now 94 and looks like a spry septuagenarian and his mind is still very quick. I had lunch with him a couple of weeks ago, and he's just so fun and boundlessly curious. The way to get his goat, the way to have him take a low opinion of you, is to be incurious. He finds politicians deeply tiresome because most of them have zero curiosity.

Greg Dowling (36:03):

I love it. So the big takeaway here is no matter what your age, be curious, and be curious in a lot of different fields. I know when it comes to politics--and we're not going to go into politics in a big way here--but I know you classify yourself as a bit of a libertarian.

Rob Arnott (36:19):

Just as an aside, I would say that both parties have abandoned anything resembling libertarian principles in the last two years. My guiding principles are personal liberty, economic freedom, limited government, and respect for the constitution. I don't see any of the four getting any respect in the last two years from either party. Deeply depressing. But enough on politics.

Greg Dowling (36:43):

Well, it's good. You hate both parties equally, which is, I think, a helpful--

Rob Arnott (36:47):

Not quite equally.

Greg Dowling (36:48):

Not quite equally, but there's some distain for both parties, which I appreciate. So being a libertarian at heart, I would think that from a philosophical perspective, cryptocurrencies like Bitcoin would be like, "Ah, that's kind of a cool concept." But the economist in you, the fundamental researcher in you might have a different view. What are your thoughts on crypto and specifically Bitcoin?

Rob Arnott (37:12):

Well firstly, I bought a Bitcoin back in 2014 and still own it. I bought it because I was curious. I don't invest in things I don't understand, and Bitcoin is something where there's a lot of things that I do understand, other things that I don't. It has no measurable value. If you do a discounted cash flow model, you get a nice fat zero as its value. But you do the same thing with holding U.S. dollars and you get a big fat zero, there's no income, never will be. And so is crypto the same as or different than any fiat currency in the world? In some ways it's the same, in other ways, it's not. Is it a stable store of value? Oh my goodness no. Look at its volatility. Is it a means of transacting? Not so much. I mean, even one of its biggest fans, Elon Musk, announced that you can't use Bitcoin to buy a Tesla anymore. So I look at Bitcoin with great puzzlement. The biggest investment mistake of my life in terms of opportunity cost was back in 2014 when I bought a Bitcoin, I could have said, "You know, this is interesting, why don't I put a quarter million to this and just watch it?" Well, it'd be worth more than a quarter million [laughs]. But in any event, be that as it may, I find it fascinating and I don't understand it well enough to use it as an investment.

Greg Dowling (38:39):

Fair enough. So I know away from investing, one of your big hobbies is motorcycles, and you've collected quite a handful of some pretty unique and rare motorcycles. What got you into this hobby, and can you share some of your favorite classic or rare models that you own?

Rob Arnott (38:56):

What got me into it was when I was in college, I was already self-supporting and, shall we say, very poor. I couldn't afford a car, so I bought a motorcycle. I loved riding, and so I've always continued to have motorcycles. In the early 90s, I decided to buy a classic bike, one that I always thought would be really cool to own, something called a Vincent Black Shadow made in the 40s and early 50s. I loved it. And so I slowly but surely began collecting. It's not a big collection, I have maybe 22, 23 bikes. But some of them are really, really special.

Rob Arnott (39:36):

I have one that's called Old Bill that was made in 1922 and was the winningest race bike in history, it won 51 out of 52 races that it was in. The 52nd race, it was the fastest motorcycle, but it went across the finish line with the rider sliding next to it, so it didn't count as a win. And his wife sensibly said, "If you ever get on that bike again, I'm leaving you." So that was its last race and his last race. That's a very special bike. I have a motorcycle that was raced at the first ever Production Racing World Championship at Imola in 1972 by the winningest racer in history, a fellow named Giacomo Agostini. And I'm actually slated to meet him and have dinner with him in about 10 weeks, so that's going to be fun. Anyway, everybody needs hobbies and things that they enjoy doing. Mine are old motorcycles, good wine, and travel.

Greg Dowling (40:36):

All right. So what is a good recommendation for an affordable bottle of wine and where is the next place that you want to go once all of the COVID restrictions globally are lifted?

Rob Arnott (40:48):

You know, winemaking has become such a science that you can get brilliant wines in the $50-$100 range, really good wines. There's a--New Zealand makes some awesome sauvignon blancs and Pinot noirs. There's a winery called Cloudy Bay that makes just an amazing sauvignon blanc. There's a lot of good choices. Don't expect to spend $25 and get a brilliant wine, but if you're willing to spend $50 to $100, ask your wine merchant and if they seem at all knowledgeable about wines, trust their judgment, try 2 or 3, and you'll find one that you really like.

Greg Dowling (41:26):

Very good. When's your next trip, and where are you going?

Rob Arnott (41:28):

For my birthday at the end of June, my wife is taking me to the South of France. We're staying at a place called Chevre D'or in a little village called Eze perched on a cliff overlooking the Mediterranean. So that's going to be good fun.

Greg Dowling (41:41):

And I'm sure there'll be great wine.

Rob Arnott (41:42):

They have an awesome wine list [laughs].

Greg Dowling (41:47):

Very good. Well, we've talked a lot about death. Death of value, death of diversification. This has been one of the more enjoyable conversations that I've had regarding death, so thank you very much.

Rob Arnott (42:01):

[laughs] Well, death is inevitable, so roll with it. Get used to it. It's fine. Unlike human death, when value dies it can come back like the Phoenix.

Greg Dowling (42:11):

Well, that's perfect. Rob, thank you so much for your time today.

Rob Arnott (42:13):

All right. Take care. Bye.

Greg Dowling (42:15):

If you are interested in more information on the topic, please go to our website where we will have a list of relevant FEG publications. And don't forget to subscribe to our communications at so you don't miss the next episode. Please keep in mind that this information is intended to be general education that needs to be framed within the unique risk and return objectives of each client. Therefore, nobody should consider these FEG recommendations. This podcast was prepared by FEG; neither the information nor any opinion expressed in this podcast constitutes an offer or an invitation to make an offer to buy or sell any securities. The views or opinions expressed by guest speakers are solely their own and do not necessarily represent the views or opinions of FEG.


This was prepared by FEG (also known as Fund Evaluation Group, LLC), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directly to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202, Attention: Compliance Department. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. Past performance is not an indicator or guarantee of future results. Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss. The views or opinions expressed by guest speakers are solely their own and do not represent the views or opinions of Fund Evaluation Group, LLC.


Join other institutional investors receiving FEG’s updates, including market perspectives, white papers,
podcast episodes, and event invitations.


Subscribe Now