As I said in the April '09 post "A Really Smart Guy On Stocks, Bonds and Expected Returns":
Robert Arnott IS one of the sharpest knives in the drawer. He lays out some high level thoughts in an approachable manner which, to my mind, is one of the signs of superior analytical thinking....Here's the transcript from the May 28 edition of WealthTrack:
CONSUELO MACK: This week on WealthTrack, financial thought leader and great investor Rob Arnott created fundamental indexing plus the first global funds to actively invest in all asset classes. What is this financial innovator cooking up now for better investment returns? Research Affiliates’ Rob Arnott is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Can you really create a better mousetrap as an investor so you will have enough proverbial cheese to see you through a lifetime? Well, that is a question we try to answer every week on WealthTrack, and it turns out there are some old-fashioned solutions and there are some intriguing new ones, which we will discuss with this week’s guest.
The years 1999 to 2009 were financially devastating to many investors. They were called “the lost decade” because the benchmark U.S. stock market, the S&P 500, lost money over the period and widely followed global stock indexes barely made money, averaging under 1% annualized returns. So much, we thought, for the notion of stocks for the long run, and therein lies the problem. Too many of us relied too heavily on stocks. Had we truly diversified across many asset classes and countries, we would have made money.
Emerging market bonds delivered nearly 11% annualized returns; Treasury inflation protected securities or TIPS nearly 8%; long Treasury bonds delivered 7.6% a year; high-yield bonds 6.7%; real estate investment trusts or REITs more than 10%, and commodities a little over 7%.
But this week’s guest says investors made another costly mistake: investing in capitalization-weighted indexes. Now, these are the very popular index funds based on the market prices of the stocks, bonds or other securities that make up the index. Rob Arnott and his firm Research Affiliates have created an alternative. They were actually awarded the patent for “fundamental index” methodology, and it replaces market value with four fundamental financial measures. Instead of stock price, the companies are valued on sales, cash flow, dividends and book value. And when Arnott back-tested the Research Affiliates fundamental indexes, RAFI for short, in different asset classes, they outperformed the old cap-weighted indexes over the decade.
For example, the large company U.S. fundamental index delivered nearly 5% annualized returns, the global fundamental index nearly 8% returns on average, and the emerging market fundamental index came in with 19% annualized returns over the decade.
Now, Research Affiliates is one of WealthTrack’s sponsors, but its chairman and founder, Rob Arnott, is considered to be one of the industry’s financial thought leaders. Editor of several highly respected financial journals with more than 70 published articles, he is also an industry innovator, creating several widely used products. I asked him what led him to fundamental indexing.
ROB ARNOTT: Well, the genesis for this actually goes back to a friend of mine, George Cain, who used to run the Common Fund, commingled university endowments, and he sat on a number of state boards and was horrified in the year 2000 as he saw more and more money being pushed into the ultra-high multiple growth stocks, the Ciscos of the world, even the Pets.com of the world, these companies that had no plausible way to earn enough money in the future to justify the then-current prices. And they became a larger and larger part of the portfolio, only because they were so expensive. He thought there had to be a better way. Why on earth should a popularity-weighted index be a good idea?
So why don’t we use company sizes and anchor to contra trade, bring the growth stocks down to their economic size, take the value stocks up to their economic size and just use that as an anchor for rebalancing. It seemed to us at the time that this is something that probably ought to work, as in probably ought to add some value. It never occurred to us how much value would be added.
CONSUELO MACK: As you've written to your clients, the lost decade from 1999, from 2000 to 2010 was not a lost decade at all, depending on how you had invested.
ROB ARNOTT: Right. And so cap weighting was one very big problem, especially in that decade because that decade was book-ended by two crises: one, what’s called the TMT bubble, the technology-media-telecom bubble and crash, and then the 2009 financial services, industrials, consumer discretionary anti-bubble, where they were collectively priced as if they might all disappear as industries. Well, how is that going to happen? Then, the snapback for the survivors. True, there were some that didn’t make it, but the snapback for the survivors was so vigorous that buying in at the bottom, when everyone was terrified, was actually a very profitable thing to do. Fundamental index gives you an objective basis to do the uncomfortable- to trim the popular, the comfort stocks, the safe havens, the growth stocks and to buy into whatever is most deeply out of favor.
CONSUELO MACK: Now the market capitalization indexes, and a lot of our viewers I’m sure have owned market capitalization index funds.
ROB ARNOTT: Of course they do.
CONSUELO MACK: And certainly some legendary individuals in the investment sphere, Jack Bogle comes to mind.
ROB ARNOTT: One of my heroes.
CONSUELO MACK: Vanguard has been a huge proponent of market cap indexes. Number one, do you know how Jack Bogle feels about fundamental indexation, and number two, do you think that the market capitalization is so flawed that it should actually be a disservice for investors to be invested in them?
ROB ARNOTT: I don’t think it’s a disservice at all. Firstly, Jack Bogle is one of my heroes. I started Research Affiliates a few months after having dinner with him knowing that he’d started Vanguard at roughly the age I was when we had dinner. So in many ways he’s my inspiration.
Jack was a pioneer. He is absolutely right that if you’re not invested at the market weight, you’re making a bet relative to the market, and for me to make a bet, somebody has to be on the other side of that bet. So for me to win, there has to be a loser. Okay. Who is that loser? It’s a zero sum game in terms of value added. But if you can identify who the loser is, maybe you’d have some more confidence in your ability to add value. The loser is the trend-chasing, comfort-seeking investor. Are there trend-chasing, comfort-seeking investors out there? Yes, legions of them. The market doesn’t reward comfort. It rewards discomfort.
One of the fascinating nuances of fundamental index is that while it has a value tilt, it makes most of its money not from a value tilt but from contra trading against the markets’ constantly changing opinions. And the value tilt, while it’s a little bit uncomfortable- you’re investing in companies that are out of favor and are cheap, and some of them deserve to be cheap- the uncomfortable part of fundamental index is what makes the most money, and that’s the trading.
CONSUELO MACK: What were some of the lessons that you learned and that we should take away from that crisis and the crisis itself and this very fast recovery as far as the markets are concerned afterwards?
ROB ARNOTT: The main lessons I think are ones that the markets teach us again and again and again. Warren Buffett says we should be greedy when others are terrified, terrified when others are greedy. Early 2009, the investment community was terrified. I was terrified. But I knew it was a great time to take risk because people were terrified of risk. A year after this the market recovers, heroically. I almost said handsomely. It was better than that. And you have so many investors, professional investors, who think, oh, thank goodness the financial crisis is behind us.
CONSUELO MACK: You don’t think so?
ROB ARNOTT: No, no. The seeds that delivered that crop, the global financial crisis, there’s more of those seeds than ever. They’re bigger than ever.
CONSUELO MACK: So Rob, what are the bigger seeds that have been planted that you think we’re going to have to face at some point?
ROB ARNOTT: Last fall we wrote a piece entitled “the 3-D hurricane.” It talked about deficit, debt and demographics. We’re spending more than we produce as nation, which is leading to a buildup of debt to be paid for by whom, a shrinking population of workforce as a percentage of the population. So how bad are each of these problems? Deficit: 10% of GDP last year. There are those who say, don’t worry about it. It’s a one-off. We have a global financial crisis; we need to spend this money to spend our way out of this mess. I could almost buy that if I believed that it was a one-off. Simple fact is that the 10% was tip of the iceberg. The accounting that got us there would have made Enron execs blush. You have off-balance sheet spending, that’s the pre-funding of social security and Medicare trust funds and a few other items. They’re off balance sheet, but they’re prefunding future obligations. They are legitimate spending. That takes you to 14% of GDP. You have the GSEs, government-sponsored entities: Fannie Mae, Freddie Mac and several others. Those take us to 17% of GDP. They’re now backed by full faith and credit of the U.S. government.
CONSUELO MACK: So there are obligations.
ROB ARNOTT: They are our obligations. A year and a half ago at midst of the financial crisis, the government said we’ll backstop these organizations. We’ll backstop them to a limit of $200 billion. February, they lifted that limit and said, no, backstop to an unlimited extent, infinite extent all by full faith and credit of the U.S. government. And oh, by the way, one of the provisions of the bill, this will not be counted as part of the national debt.
CONSUELO MACK: And they’re underwriting the entire mortgage market right now, right?
ROB ARNOTT: Corporate execs would go to jail for that, but if you write the laws, you don’t. That took us to 17% of GDP as a deficit. Then there’s unfunded social security and Medicare. We’re getting older, there’s more people, the debts are growing. That takes us to 18%. The average of the last quarter century officially has been 2.5% of GDP; unofficially with correct gap accounting, it’s been just under 10% of GDP per annum per quarter century. So this 10% deficit is not abnormal at all. We have a government and a society addicted to debt-financed consumption. That leads to the debt level. The debt level for the national debt officially is approaching 90%. That doesn’t include state and local and it doesn’t include GSEs.
CONSUELO MACK: 90% of total output.
ROB ARNOTT: Of GDP. And if you include state and local and GSEs, you’re now up to 143%. Greece, as the crisis has been blowing up there, has been in the 120% range. We’re above 140%. If you add in the unfunded portion of social security and Medicare, we’re at 420% of GDP. The corporate debt is 320%. Household debt is 100% of GDP. Combined private debt is another 420%, the largest in the world. So we have aggregate debt and unfunded future obligations eight times our annual income. If you borrowed eight times your annual income, how comfortable would you feel about your ability to service that debt in the years ahead?
CONSUELO MACK: So what do you do with that information? I mean, how does it change your view, number one, of the U.S. stock market and bond market and certainly government debt market? And how do you adjust to that as an investor so that that doesn’t destroy you?
ROB ARNOTT: Well, we’ve been talking about a lot of depressing stuff. The not-so-depressing part is that there’s always something interesting to invest in, always. The aggregate size of our debt I think almost guarantees some inflationary burst that will be daunting sooner and larger than we expect in the years ahead. I think we’ll see at least one major inflationary shock in the coming decade, two or three in the next 20 years. And by major, I do mean double-digit. I’m hoping I don’t mean hyperinflation, but I don’t think it’s impossible. The inflationary shocks mean preposition your portfolio for inflation.
CONSUELO MACK: Now?
ROB ARNOTT: Do it before inflation becomes obvious because inflation protection, protecting against anything, insuring anything is cheapest when people don’t expect it. Buy auto insurance when you have a clean record. The notion of buying tips, inflation-linked government bonds, they’re currently priced at a level that suggests 2.5% lower yield than corresponding government bonds. Okay, 2.5% means that if inflation averages over 2.5% over the next 20 years, you’re better off in TIPS. Okay, so that’s your defensive reserve.
CONSUELO MACK: Sounds like a pretty good bet.
ROB ARNOTT: It’s a pretty good bet. I think the likelihood of us managing the next 20 years with 2.5% inflation is somewhere between slim to none. Commodities, when they have their occasional 20% and 30% drops, use them, buy them. I don’t think commodities are cheap right now. I think they will be in the next recession, which I don’t think is that far off. So I think if there’s a second dip to this recession in the coming year or two, and I think there will be, that will create a buying opportunity.
CONSUELO MACK: Why do you think there is going to be a double dip?
ROB ARNOTT: Two things. Firstly, to outward appearance, the economy seems to be rebounding. It’s not showing up in the tax figures. Government tax receipts year to date are about 6% below where they were year to date in ‘09 at this time. 6% down and this is a recovery? If taxes are down, then doesn’t that mean incomes are down? If incomes are down, doesn’t that mean that we don’t really have a strong recovery yet? The recovery seems to be mostly restocking inventory, not actual demand for product.
The second big issue is taxes. Taxes will go up at the end of the year if for no other reason than the Bush tax cuts lapsing. The path of least resistance for Congress is to do nothing. It’s always the path of least resistance, and to do nothing means taxes go up 2% of GDP in one fell swoop; history suggests a three-to-one multiplier, that 1% higher taxes means 3% smaller GDP. So 2% higher means six. 6% drop in GDP, that’s a recession.
CONSUELO MACK: You created the first global asset allocation product that makes active use of alternative markets beyond stocks, bonds, and cash- I was reading from your website, which was launched at PIMCO initially So an all-asset fund that is broadly diversified across all different alternative asset classes. What are the kinds of alternative asset classes that we all should be invested in, and why is it so important to be that broadly diversified?
ROB ARNOTT: Most investors have most of their money, the lion’s share, 90-plus percent in mainstream stocks and mainstream bonds. If we get reflation, what happens to stocks? They get inflation passed through eventually, but the first impact is they go to lower multiples. It’s bad news for stocks. What happens to bonds? The yields go up to reflect inflation- yields up means prices down. Mainstream stocks and bonds are terrible assets in a reflationary world. We have a huge tool kit available to us, a whole array of asset classes. The notion of building your retirement home with a hammer, stocks, and only a hammer, stocks, strikes me as misguided at best.
There’s a whole spectrum of assets out there. You’ve got stocks and bonds, international stocks and bonds, emerging market stocks and bonds, and then you’ve got commodities, REITs, inflation-linked bonds, absolute return strategies. You’ve got a tool kit. People need to use it. Now, in a reflationary world, what protection can we seek? TIPS, the inflation linked bonds, interesting as our low-risk anchor for the portfolio; emerging market stocks and bonds. I talked about the 3-D hurricane. In the emerging markets, the average deficit is 1% to 2% of GDP, the average debt is 30% to 40% of GDP and demographics, they don’t have a wall of retirees coming their way.
CONSUELO MACK: Except for China.
ROB ARNOTT: Except for China.
CONSUELO MACK: Eventually, because of the one-child policy.
ROB ARNOTT: Exactly right. China with their one-child policy does have a retirement wall that they’re headed towards about ten years after we hit ours. So it’s not imminent, but be aware. So emerging markets in aggregate don’t have any of the 3-D hurricane. In aggregate, they have less debt, less deficit, better balance of payments, more solvency, and so from a simple financial perspective, they are more credit worthy than U.S. Treasuries. The only risk that they have that the U.S. Treasury ostensibly doesn’t have is political risk, the risk of default. We saw Ecuador decide to default even though they had money. Okay. There are consequences to that. Those consequences will be pretty serious as they’ll discover over time.
But the simple fact is you do have that political risk. It’s country by country. It’s not widespread. So I view emerging markets’ debt as a really interesting place to put your debt capital that gets you away from the U.S. dollar. Emerging markets’ stocks when they’re cheap, they were cheap a year ago. They are not cheap now. They’ll be cheap the next time we have a recession. Wonderful buying opportunity. So we should view these ups and downs in the markets not with anxiety but with a recognition that they’re creating opportunities. And if we’re tactical and responsive and go into assets when they’re least comfortable, it works. You can earn good returns.
CONSUELO MACK: Stocks for the long run- the notion that stocks are going to return 10 or 11% in perpetuity- that has gone out the window over the last decade. How should we look at stocks as investments and what kind of returns should we expect from stocks?
ROB ARNOTT: Simple fact is stocks are like any other asset class. You buy them when they’re cheap and you don’t have to wait for the long run. You’ll be happy pretty soon. If you buy them when they’re expensive, your long run may be very, very long indeed.
So when we went back over the last 200 years, and admittedly the data before 1870 is really weak data, but going back over a very, very long periods of time, what we find is some interesting things. Stocks beat bonds 100 fold over the last 200 years. You wound up 100 times as wealthy with stocks than bonds. How much does that turn into annualized? 2.5%, not 5%. 2.5% per year. So that’s a long-term history and it’s a history that includes a revaluation of stocks to lower yields, lower price earnings ratios and higher valuation multiples than we ever saw historically. Take that out of the picture and you’ve got more like 1.5% advantage over bonds. It’s not huge.
Now, second issue that’s interesting is that when stocks are expensive, you can find them underperforming bonds for long periods of time. The most recent vivid example is the trough of the global financial crisis. You can go back 40 years and you would have been better off in ordinary Treasury bonds than in stocks for a 40-year window of time. It’s astounding. And any time you bought in the last 32 or 33, years you would have been better off in bonds than stocks. It’s not because bonds are better. It’s because stocks got to valuation levels that required a major correction.
And the third thing that’s interesting there I think is that we have this widespread view that stocks loff from new high to new high to new high, interrupted by inconveniences known as bear markets. And, in fact, we find those bull and bear markets are subsumed within longer cycles, secular bull and bear markets that span decades, not years.
So what we find is that about 80% of the time in the last 200 years, we were in a window of time where it took 15 years or longer to get to a new high net of inflation. The secular bear market low in 1982 adjusted for inflation brought us back down to levels that were first achieved in 1905, 77 years earlier. The crash in ‘87 brought us back down to levels first achieved at the high in 1929, 58 years earlier. So the notion of stocks for the long run is fine if it’s with a recognition that what you pay matters and stocks are not immune to that simple fact.
CONSUELO MACK: Rob Arnott, so great to have you here from Research Affiliates. Thanks for joining us.
ROB ARNOTT: Thank you very much. It’s a pleasure.
CONSUELO MACK: I also asked Rob Arnott to give us his One Investment pick, something that all of us should own in a long-term, diversified portfolio. His choice is longer maturity treasury inflation protected securities, or TIPS. He says the long TIPS will help protect us against inflation surges in the years ahead.
Next week we’re going to focus on retirement income. On hand to tell us how we can maximize it without undue risk will be well-known financial planner Harold Evensky, Kiplinger’s retirement income specialist Mary Beth Franklin, and former Wall Street Journal personal finance columnist Jonathan Clements. Thank you for visiting with us. Don’t forget to thank veterans and soldiers for their service on this Memorial Day weekend. We would not be safe without them. Make the week ahead a profitable and a productive one.See also: