Asness vs. Arnott on Smart Beta, Factor Timing, and Performance Chasing

Cliff Asness, co-founder of AQR Capital Management, added fuel to the debate over “smart beta” investing with a recent paper attacking arguments made by Rob Arnott of Research Affiliates. Arnott, once understood as a proponent of smart beta approaches due to his research and development of fundamental indexing, claimed that many smart beta exchange traded funds “have succeeded solely because they have become more and more expensive.” In an argument that Asness describes as alarmist, Arnott suggests that a significant fall in such funds is coming. While Asness does not necessarily disagree with that point, he reads Arnott to be advocating a timing strategy to be employed along with factor analysis. “Factor timing is very tempting and, unfortunately, very difficult to do well,” Asness wrote. He continued: “I think that siren song should be resisted,” observing that “at least when using the simple ‘value’ of the factors themselves, I find such strategies to be weak historically, and some tests of their long-term power to be exaggerated and/or inapplicable.” Arnott, however, says he is concerned that “the financial engineering community [is] at risk of encouraging performance chasing, under the rubric of smart beta,” which would mean that “smart beta is, well, not very smart.” Further, Arnott, an ardent value investor, says that “it’s dangerous to ignore relative valuation outright” and “performance chasing is even more dangerous than the factor timing [Asness is] warning against.” Asness, for his part, warns against relying excessively on valuations because they haven’t predicted past downturns. “I see this as an unfortunate pain we must bear in exchange for the long-term positives of good factors,” he said, explaining: “I make the analogy to knowing that the stock market will one day suffer a short painful ‘crash’ does not mean one doesn’t invest in stocks for the long run.”