Rob Arnott, the founder and chairman of Research Affiliates, was in London this week. Ed Bowsher spoke to him.

Rob Arnott is sometimes described as the "godfather of smart beta" and is a very well-known name in the the investment industry. In 2002 he founded Research Associates in Newport Beach, California. It's an unusual investment business in that it doesn't manage funds or operate investment indices. Instead it's a research-heavy company that comes up with investment strategies that are then implemented by fund management firms and index providers.

Arnott began the interview by explaining how he came to be associated with the concept of smart beta. In summary, he came up with the initial concept but not the actual name. Arnott credits the name to Towers Watson who were inspired by Arnott's Fundamental Index strategy. Fundamental Index was an early attempt to move away from using market caps to weight an index. Instead Fundamental Index or RAFI focuses on the size of a company for the weightings.

Arnott likes the term, 'smart beta' but feels it's been abused: : 'I like the term because it's a fun term, but the term has been expropriated by the industry and applied to almost everything. It used to have a specific meaning and it doesn't anymore. It now means anything anyone wants to attach it to. If it means everything, then it means nothing. And that's where we are now.'

He cited a list of the top 25 smart beta etfs that was recently published by ETFdb.com. The top two ETFs in the list were Russell Value and Russell Growth. Arnott pointed out that if an inexperienced investor decided to invest in just the top two funds on the list, he'd end up investing in the market - the Russell 1000 list. He'd be following a traditional market-cap weighted strategy. Not smart beta at all.

Fundamental Index

Before we delved deeper into Smart Beta, Arnott wanted to explain his Fundamental Index strategy.

'Fundamental index weights companies by how big they are. There are a lot of ways to measure that: sales, profits, book value, dividends, employee numbers or a blend of those. Typically we use a blend.

'And if you weight by the size of the company, the markets see some companies and say "this company has wonderful growth prospects" and prices them at a premium multiple. Fundamental index will take a view that it might be a great company, probably deserves a premium multiple, but the good news is already in the share price.'

So it makes sense to reweight that growth company down to its economic footprint or its size.

'The important thing about the weighting is that you're taking growth stocks down to economic footprint and you're taking value stocks to economic footprint. So you always have a value tilt… but it's a very special value tilt. and it's a dynamic value tilt. The more the market is prepared to pay for growth companies, the bigger the value tilt. If the market is paying a small premium for growth, it's a small value tilt. If the market is paying a huge premium for growth, like it is today, it's a big value tilt. And it's the dynamic character of the strategy that is the source of Alpha.'

Where smart beta has gone wrong

Going back to Arnott's criticism of Smart Beta as it's sometimes implemented, his concern is that some of the so-called Smart strategies aren't smart at all. They all work in back-tests but when you start running them in real time, many don't do so well. And even the best ones only out-perform some of the time.

Arnott argues that we need to consider valuation if we're going to increase our chances of success with a factor-based strategy. So, for example, if we looked at the quality and value factors, he'd want to see how current relative valuations compared with the past. You'd normally expect quality to be more expensive than value, let's say a 30% premium would be about average. So if quality is trading on a 20% premium to value, then that might be a good time to tilt your investment towards quality. Quality is relatively cheap at that point. But if the premium was 40%, then it might be time to tilt your investment towards value.

Momentum

Arnott also had some interesting thoughts on momentum investing:

'It takes the problems associated with cap-weighting and magnifies them. Cap-weighting hurts you because whatever is over-priced you're overweight in, and whatever is under-priced, you're underweight in. And if you attach momentum to a cap-weighted portfolio, you're magnifying that. So momentum has a major structural problem, but it works over very long periods of time. And it works for a little while. But you better get out of those positions pretty fast or it will hurt you, and that's something many momentum investors don't realise.'

In other words, if you're going to be a short-term momentum investor, you've got to keep a close eye on your investments and bank profits quickly.

What about now?

Arnott reckons that value is the only factor that looks cheap at the moment. Value in the US is 'modestly cheap', it's 'cheaper' in international stocks, and is 'extremely cheap' in emerging markets. He suggested that one reason for the cheapness in emerging markets is that 'stories dominate emerging market valuations', so you get stocks like internet company, Tencent, in China which has a good story but trades on a high very high valuation. That, in turn, creates opportunities in the value section of the market.

If you want to find out more about expected future returns of different factor strategies, Research Affiliates has set up the SmartBeta Interactive website which provides expected return models for each strategy.

Once you've spoken to Arnott, the importance of considering value in a factor-based strategy seems obvious. So the author of this article certainly thinks his meeting with Arnott was time very sell spent.