Season 3 Episode 7:
Bubbles, Quants and Value

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This week’s guest is Rob Arnott, quant researcher and founder of Research Affiliates. We discuss the principles of fundamental indexing, the definition of bubbles and anti-bubbles, the future of value investing, what quant researchers tend to get wrong, and the right questions to ask of any backtest.

We put some big questions to Rob including: has factor investing been oversold, can passive investing get too big and what should you really ask your active manager?

We discuss: 

  • There’s always a lot of talk about bubbles. We talk about Rob’s framework for trying to identify them in real-time and what we can learn from it.
  • Does a valuation require implausible assumptions? 
  • Does the marginal buyer care about valuation models? 

Interestingly on the day that we were recording this Tesla passed a $1trn valuation, this also throws up the possibility of anti-bubbles, those where you need to use implausibly bad assumptions to arrive at the price. We also discuss what investors should actually do about bubbles, given that they can go far further and longer than you expect. 

One theme that came up throughout the conversation with Rob was the need to always reflect on the expectations built into stock prices. Great companies can easily continue to succeed and grow earnings while being disappointing investments as the success was already priced in.

Value investing. One of the big questions of our time, we discuss:

  • The underperformance of value strategies and how this varies depending on the definition of value used (from a 3-year bear market to a 13-year bear market).
  • The change you can make to traditional measures eg adapting the price to book ratio to include intangibles, as we need to combine multiple definitions.
  • The fact that a large part of the underperformance of value is related to its cheapening in fundamental terms compared to growth.

Have factor strategies been oversold? 

  • Trading costs are often understated and diversification overstated. Backtests are relied upon too much.

Trading costs & backtests : reasons to be sceptical and the right questions to ask 

  • Trading costs are often not properly built into backtests and the right questions are not answered such as: how has the growth in popularity of this factor explain the apparent high returns, and have a large proportion of a factor’s returns come from very small and illiquid stocks that are hard to trade?

Can indexing get too big?

  • No, not if representative of the whole market, but Rob makes the case for breaking the link between price and index weight, and pushes back against the caution to avoid tracking error to standard indices.

Maverick risk

  • Many investors look to peer groups more than their benchmark or liabilities and this is often the true risk at play, relating to career risk. Hard to mitigate as requires going against human nature, looking back, and facing up to the reality of your decisions. 

One thing to take away

Pay attention to narratives and ask the question – is this reflected in share prices? Is it going to matter in 5 years? What is the market missing in this narrative? What nuances is the market overlooking?

The most underappreciated thing about investing

The importance of not following crowds – the market doesn’t reward comfort, if a decision feels comfortable and right then it’s probably a bad decision. If it feels uncomfortable it is more likely to be rewarded.


Rob’s recent research referenced in the discussion:

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