Rob Arnott, Research Affiliates

After about seven years. I went to Salomon Brothers after about three and a half years. Salomon was a very short stint. It was during the crash of 87, and it was a fascinating lesson in how office politics can be a big factor. They had a sharp elbows culture. Which doesn't mean it was bad. It was fun, but it was an interesting culture. Deep dive. Then I went to build First Quadrant, and in 2002 decided if I'm ever going to start my own business, I better start it now. And so I started Research Affiliates back then. I actually ran both businesses side by side for two years. And after about two years, it was clear that I could finally pass the baton at First Quadrant without them losing any clients. And meanwhile, Research Affiliates needed

My full time.

That's for you to be pretty well. By the way, I no longer hate you. And I thought, okay, that's interesting. Why did you hate me? And he said, because you wrote death of the risk premium. I built my entire career on the notion of a risk premium. And that was a fun aha moment. Okay. You rattle people's cages and some people are going to be angry because you're going to be challenging the core principles of their career. So as it happens, we published fundamental index, fundamental indexation in 2005 and 2007, Towers Walksum, the consultancy out of London coined the expression smart data. And the inspiration for that was fundamental index. They realized, okay, this is a quasi passive strategy. It's, it owns the whole market, but it owns it weighted according

To the economic footprint of the business is not their market value. And what makes it interesting is it has a rebalancing alpha. If a stock soars and the fundamentals don't validate that move, Rafi is going to trim it and take profits. And if his stock tanks and the fundamentals don't validate that fundamental index is going to say, thanks for the bargain and top it back up. That rebalancing alpha is worth about 2% a year. So they coined the expression smart beta. And, um, pretty soon everybody was saying they did smart beta. Um, smart beta started to encompass a lot of smart ideas and a lot of stupid ideas and a lot of, uh, uh, ideas. And, uh, uh, anyway, it's, it was marvelous fun, but Ramsey itself, uh, has gone on. It's now got a 20 year live track record. It's beat cap weighted,

Uh, value, not the cap weighted market per se, but cap weighted value in about three out of every four years. If value is winning, we're winning by more. The value is losing. We're losing by less. And so relative to cap weighted value indexes, the relative performance has been both relentless and impressive and that's live for over 20 years. Um, so it has been a lot of fun launching a bit of

Current AI, uh, narrative are, are these companies worth this magnitude of premium? Well, firstly, to state the obvious only time will tell, but lessons from the.com bubble are very simple. The.com bubble began with a narrative. The narrative was the internet will change everything. It'll change how we get our goods and services, how we maintain friendships, how we communicate, how we socially network. It'll change, um, how, how we get our news, how we do our research. All true. The narrative went on to say, these are the dominant companies and they all have a moat.

It's going to be very hard for anyone to break in. Well, moats are good to protect you for two years, three years, five years, not for 10 years, not for 20 years of the 10 most valuable tech stocks in the world. In the year 2001, Microsoft has beat the S&P and you had to wait 18 years for that to happen. You bought Microsoft in the year 2000. You had to wait until 2018 before you were ahead of the S&P. Now you're handily ahead by two, two and a half percent per Anna. All right. The other nine are behind the S&P and half of them actually have a negative total return.

So, um, the narrative that these are the dominant players and will remain dominant as far as the eye can see is, is I think a little naive. The narrative that embrace of AI will happen faster than we can imagine, I think is a little naive. People embrace change gradually and grudgingly. So those are the impediments. Bottom line is these are brilliant companies. They deserve a premium. They're trading at a premium that's perhaps larger than they deserve. And in that sense, it resembles past bubbles. So I think the AI, um, narrative has fueled a little bit of a bubble. I think the value is extraordinarily cheap. Small cap relative to large cap is extraordinarily cheap.

Non-US relative to US, especially on the value side is extraordinarily cheap. So I think there's some real bargains. And I also have been a lifelong believer that you want to average into the bargains. Don't just buy it because it's cheap. Nibble at it and average out of your winners. Don't sell because something has soared. Start to trim it lightly. And if you do that, you're going to wind up having less exposure when something press and, and peak exposure when something troughs.

It's like an emerging growth manager, um, uh, on steroids. You're buying stocks typically at twice the market multiple after they've doubled in the last couple of years. You're selling stocks typically at half the market multiple after they've underperformed by about 7,000 basis points on average. Um, these are horribly costly blunders and they go unnoticed because it happens at the margin because the turnover is so low. What if you change that and just say, I'm not going to buy stocks just because they soared. I'm going to buy stocks because the business has gotten big enough to matter.

I'm not going to sell stocks just because they've tanked. I'm going to sell them because their business is no longer big enough to matter. Fundamental selection, cap weighting. Um, RACWI US research affiliates cap weighted index. RACWI for the US has about 500 names in it. Very similar to the S&P 500. It has 400 stocks overlap. 80% of the names, but 95% of the weight is the same companies at the same weights because they're both cap weighted. That little 5% difference. You go back 30 years. It makes a difference of 70 basis points a year, which means that the 5% must be having about 14 percentage points, annual difference in performance.

So this idea, um, we launched it as an index in September of 2021. It's beat the S&P by a little over 90 basis points a year for four and a half years with half a percent annualized tracking error. Uh, we launched and well, actually ETF architect launched the ETF Rouse RAUS last September. It's already 90 basis points ahead of the SPDR in six months. And it's got a 99.9% correlation. So if you're within a whisker of a hundred percent correlation and you're 90 basis points ahead after six months, that's pretty cool.

Um, it's not at risk of having any liquidity constraints because the current AUM is about 40 million. So there's room for it to grow by, let's say, uh, a factor of, uh, two or 3000. Um, I have little doubt that it's going to be an enormous success, but it's, it's fun in the early stages. And by the way, the fee they're charging for, um, uh, for the first year is zero. Yeah.

Okay. If it's cheap, it's value. It'll include some value traps that deserve to be cheap or are on their way to zero, but it is value. The expensive is expensive. Expensive isn't growth. Expensive is expensive. Um, so why not choose stocks for a growth index, not based on how expensive they are, but on how fast they're growing? Makes absolute sense. We have an article in the current edition of the Financial Analyst Journal just came out last Friday and, uh, it's called fundamental growth. And, uh, I think it's going to be as revolutionary as fundamental indexation was 20 years. Um, choose stocks, choose the 25% of the market that is growing fastest by percentage annual growth.

Let's say over the last five years in sales, in profits. If R&D is broken out on the P&L, then look at five-year growth in R&D spending. Because if you've got a growth company that's spending less and less on R&D, that's a red flag. So look at those five-year growth rates and choose companies that are growing fast. So then how do you weight them? By market cap? No, that's going to put most of your money in the frothiest of them. Weight them by the dollar magnitude of the growth. The two biggest stocks in Raffi growth are Apple and NVIDIA. Both of them have a little over a 10% weight.

Think what that means. That means that these companies individually, Apple alone or NVIDIA alone, 10% of all growth in profits or sales in the U.S. economy in a single company. Very, very cool. The other thing that's fascinating is two of the MAG-7 don't qualify for our growth index. Alphabet, excuse me, Amazon and Microsoft had stupendous growth in the 2010s and very nice growth this decade, but not in the top 25%. So they got kicked out of our index.

So fundamental growth. If you go back over the last 30 years, this very simple approach to growth investing beats Russell growth by 4.5% per year for 30 years. So I told the team, I love the concept. If it's not a brilliant product, we aren't going to launch it because the last thing we want is for people to say, oh, the last value manager standing just threw in the towel and created a growth strategy. No, we're creating a growth strategy because some people do invest in growth and this is just a better way to do it. So that's fun. And no, there's not an ETF available for the index at this stage.

It'd be kind of shocking if there isn't one before the year is out.

So it goes unnoticed because I don't think anyone has studied the active side of indexing to the extent we have, even though indexes have been around for decades. So CFA Institute has a research foundation. They asked us to write a research paper, a monograph on the active side of indexing. And one of the things we explore is the cost of flip-flops. Another thing we explore is the impact that the flow of capital into indexes is having on driving a wedge in valuation between members of the index and non-members. So that section of the paper is called membership has its privileges.

And if you look at the S&P versus non-S&P stocks or Russell 1000 versus non-Russell 1000 stocks, the performance gap has been a couple percent a year for the last 30 years. But the growth in underlying cash flow has been a couple percent per year the other direction. Smaller companies are growing faster and yet getting cheaper. So you have this spread in valuation that is just humongous. It's astonishing. And that also represents a marvelous opportunity for the long-term patient investor.

And it's not just for one year. It persists for about five years. Now, the thing about deletions is these are unloved companies that are typically kind of a mess. And they're traded as if they're unloved. And removing them from the index kicks them down another notch so that their valuations are appropriately low and perhaps more than appropriately low. And that is to say, lower than they should be. That index, if you go back again 30 years, you find that it wins an average of 5% a year.

It's not as reliable as Rafi or as Raqui. It's kind of a coin toss. It wins half the time. It loses half the time. When it wins, historically it wins by an average of 18%. When it loses, on average it loses by about 5%. We launched it as an index in mid-2024. The next ETF came out in September of 24. It's underperformed by about that 5% per annum, which could be viewed as deeply depressing. Or it could be viewed as, wow, these stocks are getting really cheap.

They're really unloved. So I've actually been buying in the last couple, three months because I want to be there when it has that 18% pop.

I've seen people blow up their careers by trying to succeed too much too fast. Your customers have to be the big winners. If your customers are the big winners and you're winning because they're winning, that's the best of all worlds.

They can distribute PIMCO or Invesco. And a host of others can leverage our efforts because they have distribution teams. And we leverage their efforts because we're singularly focused on product innovation. So, our website. One part of the website that I would point people to is Asset Allocation Interactive. It provides forward-looking in your return expectations on 160 different asset classes. It's our effort to get people to not buy what's gone up the most, but to buy what might go up the most in the next 10 years.