On the other hand, knowing the P/E of a momentum strategy 10 years from now will provide us little information, as the stocks held by the portfolio could be 100% different than the stocks held today.
While to some this debate may seem pedantic, which side is ultimately correct is critical for ETF investors, who have been some of the earliest and largest adopters of “smart beta” factor products. Some questions that hinge upon this debate:
- Has the proliferation of smart beta products caused an increase in valuations for certain factors?
- Do intra-factor valuation spreads imply a time-able premium?
- Are the historical premiums arising from certain factors really only valuation multiple expansion?
- Do valuations even matter?
That last questions seems particularly arrogant against the backdrop of the 2000s, but Asness would argue that in many cases (i.e. high turnover portfolios), they don’t.
In our opinion, this debate has ramifications not only for investors moving towards single-factor solutions, but also those adopting newer multi-factor solutions. To date, product manufacturers have taken two approaches to building these portfolios: integrated and mixed.
The integrated approach seeks to identify the stocks that score highly across all factors simultaneously. Integration, in a way, performs the timing implicitly: a momentum stock is not worth buying if it is overvalued. Therefore, we would expect that this would be the preferred method of Arnott.
The mixed approach relies on building unique portfolios for each factor and combining these portfolios using a sleeve-based methodology. This is the approach we believe Asness would prefer, as he believes that turnover within a momentum portfolio is too high to make valuation a relevant metric.
SEE MORE: Investors – Why Your Diversifier Isn’t Diversified
While determining who is right or wrong in this debate would be nice, we’re sure the real answer probably lies in between. Ironically, while Asness had the final word on the topic during the Morningstar conference, he spent it somewhat defending Arnott’s approach. “It’s very important to view these things in a portfolio context,” he said. “The way Rob does it is allowed; you’re allowed to have a value-first philosophy.”
Perhaps that is the most illuminating takeaway. You’re allowed to invest however you want: just make sure you know what it implies for your investment philosophy.