Rob Arnott on Quant Investing: Opportunities and Pitfalls

In a podcast interview last month with the Investment Innovation Institute, Research Affiliate’s Rob Arnott discussed a range of issues related to factor investing, quant strategies and research with host Daniel Grioli.

Here are some highlights:

  • “There are no bargains in the absence of fear, and fear is usually rooted in a narrative of things that could go wrong,” says Arnott, adding that opportunities present themselves in stocks that are out-of-favor, unloved and have inflicted pain and loss on investors in the past.
  • While all fund prospectuses emphasize that past performance does not forecast future returns, Arnott points out that performance chasing still occurs.  Imagine a situation, he says, where a department store advertises, “new prices, 20% higher than last year” that would entice customers in to buy. “That doesn’t happen,” he quips, “except in the stock market.”
  • Buying what is “unloved,” argues Arnott, is a “better way to invest for the long-term, patient investor.” But since you can’t know where the bottom is, he adds, “you will almost assuredly buy too soon, and look like an idiot until it turns.”
  • Arnott identifies emerging markets as a possible bargain, given that the spread between its value and growth stocks is the widest it has ever been.
  • On factor timing, Arnott says those that claim it doesn’t work “haven’t done their homework.” The reticence that exists in this regard, he explains, is because some have begun treating factors as if they’re detached from the underlying companies. Factors and strategies, he notes, can become overpriced. “One of the big failings of the quant community,” says Arnott, “is that we view everything as a signal instead of as an asset.”
  • When asked how to size a position once there’s a strong signal relative to a particular factor, Arnott underscores the importance of looking back at the dispersion of historical returns and asking yourself, “how big a bet am I willing to make that won’t prompt me, my investment committee or my client to second-guess the decision in the face of a couple of bad years back-to-back?” Customers, he emphasizes, are not helped by a “brilliant strategy in which they pull the plug at exactly the wrong moment.”
  • Arnott notes that there is now more focus on tax-aware investing strategies than there was a few decades ago, and that ETFs have made it much easier to create tax-advantaged portfolios.
  • “Any research is data mining,” Arnott explains, “but all data mining is not research.” He argues that the quant community is unwittingly engaged in performance chasing when it returns to the same data “again and again in an effort to tweak the process. That’s a sure path to a better back test and a worse live experience” for the investor. He warns to be wary of quant investors who forget that they’re investing in financial assets, in “slices of a business.”