By Len Costa
In today's opening session of the Second Annual CFA Institute Middle East Investment Conference in Abu Dhabi, Research Affiliates founder and chairman Robert Arnott offered a sobering analysis of the impact of deficits, debt, and demographics in developed markets on the outlook for traditional asset classes.
In the United States, he noted, the "effective deficit" has averaged 10% of GDP per year over the past quarter century, once unfunded entitlements such as Medicare are accounted for, a level that is "unsustainable and dangerous." Aging populations in the U.S. and other countries like Japan make the investing outlook even murkier, he told Conference delegates. When debt burdens are too large, there are simply no good options. Governments have three choices, Arnott said: Pay the debt, abrogate, or reflate.
All of this is especially chastening for proponents of the "stocks for the long run" thesis. As Arnott pointedly noted, stocks "don't have inherent superiority," and in fact they lost out to Treasury bonds from 1968 to early 2009, raising questions about how long the "long run" often turns out to be. Looking ahead, he argued, "above-average valuations in the face of tremendous uncertainty — re-regulation, deleveraging, protectionism, and deglobalization — isn't compelling from a risk and reward standpoint." Instead of nominal expected returns from equities of 8-10%, investors should lower their expectations to a more reasonable 5%.
Bond investors must also recalibrate, Arnott argued. Future long-term bond returns closely follow the entry yield. With today's yields averaging 3%, the trailing 30-year return of 8.9% is hardly a reasonable expectation for the coming decade. A more sensible prediction is roughly 3%, he said.
The upshot? A "carefully crafted, well-executed departure from the classic 60/40 portfolio can move portfolios materially towards aspired returns," Arnott argued.
One such departure is fundamental indexing, an approach that Arnott and his firm helped pioneer. To illustrate its value in generating alpha, Arnott highlighted 10-year annualized return figures through December 31, 2010, the so-called "lost decade" for equities, a period in which even the classic 60/40 portfolio barely beat the inflation rate. Over that time, a variety of fundamental indexes weighted by economic size all handily outperformed comparable indexes weighted in the traditional manner — by market capitalization. In some asset classes, such as emerging markets, the differential was substantial: 24% versus 16.2%.
"Strategic allocations" that blend exposure to fundamentally weighted indexes as well as asset classes such as Treasury inflation protected securities, hedge funds or high-yield bonds, along with strategies like global tactical asset allocation, can help investors achieve a targeted 7-8% annual return, Arnott said.