Rob Arnott: Investment Outlook (June 2012)

Friday, June 1st, 2012

Institutionalizing Courage

June 2012

by Rob Arnott, Research Affiliates (RAFI)

Imagine a boss who is generally supportive of your efforts, but has some odd tendencies around rewarding initiative. Let’s call him Mr. Market.1 Every time you go in for your annual review, Mr. Market gives you a raise which is usually 1% or 2% above inflation, and asks, “Whaddya think?” If you’re “passive” and take whatever Mr. Market offers, you wind up with a steady but modest increase in your income, year after year, assuming the company is still doing well. Mr. Market, however, does not view all projects equally. If you offer to take over some project that he hates, he boosts your raise by an average of 3–6%. With a little initiative, you can triple the average real raise—over and above inflation—that everyone else is getting.

Unfortunately, Mr. Market is also bipolar, with wide mood swings. If you’re willing to take on a project that he really hates, he may give you a 15% raise, just to get it off his desk. On the other hand, if you’re taking a project that he doesn’t much mind doing, he may actually take away some of the normal raise. Because you run this risk every time you propose to take on a new project, it takes a modicum of courage to make these offers to the boss.

With a boss like Mr. Market, what is the right strategy for success? The answer is obvious: You need the courage to stick with the profitable strategy through the good times and the tough times. We’ll come back to Mr. Market shortly. First, we need to understand the true nature of wealth, income, and spending. Sustainable Spending as a Strategy Although people tend to measure wealth in terms of the dollar value of a portfolio, we believe it is better to measure wealth in terms of the real spending that the portfolio can sustain over the entire life of the obligations served by the portfolio. In 2004, we coined the expression “sustainable spending,” to gauge this true value of a portfolio.² Jim Garland used the term “portfolio fecundity,” to describe much the same concept.³

Consider a simple thought experiment. It’s a bull market. Prices double on everything we own, while the dividend yield drops in half. Are we better off? The long-term spending that the portfolio can sustain hasn’t changed a bit. In 1997, Peter Bernstein and I⁴ pointed out that bull markets are actually very bad news for those who are net savers, building a portfolio to fund future needs, because it costs more to buy the same real income stream (a very crude measure of sustainable real spending⁵) after the bull market than before. We’re better off only if we’re spending from the portfolio immediately, not saving more for the future!

Many people felt jubilation at the peak of the tech bubble, because they felt so wealthy. And they were—as long as they were inclined to liquidate their holdings and spend before the market lost its euphoria. If they were still investing (e.g., for some future retirement), those new purchases bought precious little yield! Reciprocally, people felt panic and dismay at the 2009 trough of the financial crisis, because they felt as if their assets had been wiped out. And they were—if they intended to liquidate and spend their assets immediately. But, for the buyand- hold investor, their real income was higher than at the 2007 peak!

None of this is unfamiliar to the serious student of capital markets. So, what lessons can the thoughtful observer learn from “sustainable spending”? In the following discussion, we find bear market drawdowns have little impact on sustainable spending. Indeed, these sell-offs provide opportunities to increase our sustainable spending through disciplined rebalancing between asset classes or within asset classes, especially volatile ones like equities.

This requires courage: “no guts, no glory.”⁶

What is Wealth?

Ben Graham liked to distinguish between a temporary loss of value and a permanent loss of capital. The former is a rebalancing opportunity; the latter is a disaster. In a highly diversified portfolio where all the idiosyncratic risk has been diversified away, the latter is extremely rare. At some time during the 20th century, the stock markets of Argentina, Russia, Germany, Japan, China, and Egypt each went essentially to zero. Suffice it to say those investors had much bigger things to worry about than their stocks! Temporary losses of value are frequent; at times they can become so frightening that they become permanent—for those that sell. Through the lens of sustainable spending, these losses are far less severe. Table 1 illustrates the 10 bear markets larger than 30%, in real total return, in the past century. These aren’t as rare as most people think! The average loss is a horrific 46% real return loss (including dividends, but before taxes). Our nest egg is chopped in half, usually in less than two years. That’s awful… for anyone who wants to spend all of their money at the trough.

For those focused on the spending power of the portfolio, most of these monster bear markets were surprisingly boring. The peak to trough decline in real dividend distributions was a scant 3% drop, on average. Even in the Great Depression, real dividend distributions fell by “only” 25%. Of course, the drop was worse in simple nominal terms, because we had deflation. A 25% cut in real spending power on our portfolio, while very unpleasant, was small relative to the 80% real loss of portfolio value… and it was temporary. This 25% drop in our real spending power was the single worst outlier in a century.

On average, real sustainable spending sagged slightly during these 10 worst bear markets, then recovered massively, on average by 35%, off of their lows just five years after the market trough. In almost every case, our real distributions also achieved new highs, relative to our pre-crisis spending, besting the dividends of the previous market peak by an average of 29%! Keep in mind that this is the increase in real dividends, not just nominal payouts.

For those focused on the level of real spending, rather than the level of prices, the worst market downturns in U.S. history were mostly brief bouts of minor disappointment. The results in the recent Global Financial Crisis bear a special mention. While U.S. stocks tumbled by 51%, the real dividends distributed by the S&P 500 Index grew by 4%. To be sure, the real dividends have given up that 4% gain in the subsequent three years. But, from the perspective of spending power, these past 4½ years have been utterly boring and benign! For the buy-and-hold investor, bear markets aren’t nearly as bad as they seem. Massive market corrections disproportionately impact market prices versus spending power. But our proposed shift in our focus—drawing attention away from the value of our portfolio toward the spending power it can sustain— requires real courage: courage to ignore headlines, our brokerage statements, and our natural human instincts to sell.

Return on Courage

Now suppose we have the nerve, not only to focus on our real sustainable spending, but also to seek to increase our real sustainable spending in market downturns! If we rebalance into higher yielding assets after they’ve cratered, presumably funded from assets that have performed much better, we can systematically ratchet our sustainable spending ever higher. This ground is amply explored in asset allocation literature. Indeed, the essence of Tactical Asset Allocation (TAA) is an effort to rebalance into investments when they become most uncomfortable, and are therefore priced with a superior risk premium, to reward those who are courageous enough to invest at such times.

Even a mechanistic rebalancing policy would have compelled a trade from stocks into bonds at the peak in 2000. The trend-chasers who bought stocks at the peak, let alone buyers of high-flying growth or tech stocks, may not live long enough to be wealthier than their contrarian friends who bought ordinary Treasury bonds at that same time. They funded the success of TAA managers and strategies. Conversely, in 2009, a disciplined rebalancing strategy compelled us to buy “Anything but Treasuries.” Treasuries had dipped to the lowest yields seen in three generations. At the same time, almost anything else offered generous future spending, with many markets priced at near-record yields. Still, this was a very frightening trade.

Tags: Bipolar, Boss, Courage, Dollar Value, Expression, Good Times, inflation, Initiative, Investment Outlook, Market 1, Modicum, Mood Swings, Profitable Strategy, Rafi, Research Affiliates, Rob Arnott, Tendencies, Tough Times, True Nature, Wealth Income
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The Newlyweds Dilemma (RA)

Friday, April 27th, 2012

by John West, Research Affiliates LLC

For most adults, the New Normal of their personal lives starts not long after saying “I do.” The habits, schedules, hobbies, possessions, and even relationships garnered over the past 10 or 20 years must be altered or outright replaced. Married life changes one’s priorities, and priorities change just about everything. Nowhere is this more evident than in the disappearance of free time. Building a new life together, it turns out, is quite the time commitment. For most men, the big game over the weekend is out—replaced by, paraphrasing Will Ferrell in the movie Old School, “a nice little Saturday” at the Home Depot to buy some wallpaper and flooring. For women, “girls’ night out” becomes a rare treat. Unless the new spouse can find more hours in the day, the discretionary time of our single years fades sharply.

Our 3-D Hurricane¹—the interconnected influence of relentless deficits, soaring debt, and an aging demography—is creating a similar demarcation for investors. Old investing patterns—for example, tracking error to the ubiquitous 60/40 blend of mainstream stocks and bonds, the comfortable reliance on “first-world” developed markets, and conventional cap-weighted indexing—may not fit with our new investment priorities: more effective inflation protection, absolute returns and better Sharpe ratios, a greater emphasis on developing economies and markets, and so forth.

In this issue, we explore ways investors can make the break from the “mainstream” investing approaches to which they have become accustomed to approaches that will position them better for the future.

The Volatility of 3-D Hurricane Assets

It is a simple fact that mainstream stocks and bonds empirically do a very poor job of hedging against inflation, especially in the early stages of renewed inflation. It is also self-evident that stock and bond yields—especially in the United States—are both well below historical norms. For these reasons, we suggest that most investors begin building a “third pillar” to their stock and bond allocations. The third pillar would encompass a mix of real return investments. We also suggest that investors adopt a tactical asset allocation component to address the higher volatility and more frequent dislocations found in these asset classes.

Our inflation fighting toolkit includes an array of assets that can shelter us from the growing 3-D hurricane.² These include both the traditional real return asset classes (TIPS, commodities, and REITs) and a set of “Stealth Inflation Fighters” such as emerging market debt, high yield, and bank loans. Typically, the volatility of these asset classes is higher than mainstream stocks and bonds, as the highlighted lines show in Table 1. For many investors, these asset classes “feel” even riskier, due to their large “tracking error” relative to our classically invested 60/40 peers. After all, while no investor likes losses, there are few more lonely feelings than “wrong and alone,” as Peter Bernstein liked to say.

Given their credit exposure and in some cases currency and political considerations, it is not surprising that the income-oriented assets like emerging market debt, high-yield debt, and bank loans have higher volatility levels than a core bond portfolio. Even TIPS, immune to credit risks, have posted higher volatility than the BarCap Aggregate Bond Index. Likewise in growth assets, we find the upper end of the risk spectrum’s favored 3-D assets have higher risk profiles than mainstream stocks as measured by the S&P 500. Commodities, REITs, and emerging markets equities all provide additional incremental risk. If volatility is your currency, inflation protection is a pricey proposition.

We expect this trend to continue. None of these assets is as widely held as mainstream asset classes, and are among the first to be abandoned in times of crisis. These asset classes also represent much smaller markets in terms of total size, which makes them susceptible to trend chasing.

So, how much would volatility increase with the Third Pillar of real return assets? To estimate the increased volatility, we compare a “Typical U.S. Plan” with one that includes a third pillar of real return assets.^3,4 The Typical U.S. Plan shown in Table 2 sports an 80% mainstream markets/20% Third Pillar split, and a projected long-term (10-plus years) volatility of around 9%—not all that different from the realized standard deviation of a 60% S&P 500/40% BarCap Aggregate Bond Index over the past 20 years. We contrast this with a 50/50 blend of mainstream and Third Pillar assets (labeled “Building a Sizeable Third Pillar”), which results in an annual portfolio volatility of 10.5% versus the 9.0% standard deviation level for the Typical U.S. Plan. To be sure, the Third Pillar assets have some diversification benefit, but their near-universal higher volatility levels still result in a 16% increase in total portfolio standard deviation.

When the overwhelming trend is to de-risk client portfolios, such an outcome would be unacceptable regardless of the perceived long-term benefits of such an approach. Even if the headline optics can be overcome, a poor start would likely doom such a strategy (and importantly the investment officer who recommended it!). This situation begs the question, “Can we reduce risk in other areas to allow us to spend more of our risk budget on these 3-D favored assets?”

Luckily, we see a spectrum of attractive options for investors concerned with volatility. As part of our ongoing work on alternative betas,⁵ we have devoted substantial time and resources exploring why low-beta stocks tend to generate higher returns than their high-beta brethren. Our research suggests that low-volatility strategies do indeed reduce risk and increase return, allowing them to be a critical component of an effective asset allocation for the challenging times ahead. Their potential role is reflected in the third column of Table 2. We’ll come back to this point shortly.

Enter Low Volatility Equity

A natural first step in any budgeting process is to examine the largest outlays for potential cuts first. Risk budgeting is no different. The vast majority of portfolios—pension, endowment, target maturity DC funds, and retail—are dominated by equity risk. Depending on the level of diversification, equity risk typically comprises between 90% and 99% of the total portfolio level of volatility.⁶ In our effort to “make room” in our risk budget, any reduction of equity volatility is a welcome first step, as long as we don’t have to forego our much-needed “equity risk premium.” At least historically, we don’t!

As you have probably noticed, the arena of non-price-weighted indices (also known as alternative beta) has become quite crowded since we introduced the Fundamental Index^® methodology in 2005. Among the new entrants are a number of strategies targeting low-volatility stocks and/or minimum variance. The low-volatility strategies fall into two broad categories: (1) Optimized Strategies, which model expected returns, volatilities, and correlations of individual stocks (using a variety of statistical methods and risk models) to build a minimum volatility portfolio, and (2) Heuristic Strategies, which use rules to exclude high beta/high volatility stocks, and/or assign greater weights to lower beta/volatility stocks.

A detailed review of our research effort into the many flavors of low-volatility equity investing is well beyond the scope of this discussion, but we can highlight a few points here:

- Low-volatility strategies—both optimized and heuristic—produce returns 1–3% above their respective cap-weighted benchmark indices, using U.S. data back to the 1960s. International and emerging markets results offer similar gains over shorter stretches.

- Both Optimized and Heuristic approaches show very tightly clustered risk reduction, averaging about 25% less volatility than the cap-weighted benchmark (e.g., reducing volatility from 16% for the S&P 500 to about 12% for a low-volatility strategy).
- Nearly all methods tested produced sizeable tracking errors (8–10%) to cap weighting.

We can validate these findings by examining the published results of the S&P Low Volatility series, a heuristic-based approach that selects low beta stocks and weights them by the inverse of beta.⁷ Launched in 2011 with data backfilled to various start dates, Standard and Poor’s has a U.S., a non-U.S., and emerging market variant of the low volatility strategy.

As Table 3 shows, the S&P Low Volatility indices are consistent with our simulated research results. For the U.S. market, the S&P 500 Low Volatility Index produced an annualized return of 10.5% versus 9.3%. This 1.2% percentage point excess return was accompanied by a 25% reduction in portfolio volatility (12.5% versus 16.6%). The non-U.S. and emerging markets low-volatility strategies produced even better risk-adjusted results. And, consistent with our research, the tracking errors for all of these indices are very large—9% to 11%.⁸

Of course, the traditional backtesting caveats apply to these results, especially in the case of low volatility strategies spanning a decade dominated by the bookend bear markets of the Tech Bubble and Global Financial Crisis. On the opposite side of the ledger, the excess returns for the low-volatility strategies are very similar to other non-price-weighted indices over the same time periods. If such disparate weighting methods as the Fundamental Index methodology and equal weighting produce similar excess returns, then an excess return from weighting by the inverse of volatility should have a similar expected result. Shocking to the casual observer, high-vol and low-vol both beat the market, by comparable margins, as long as the portfolio weights are indifferent to price!

Of course, we are comparing paper portfolios that do not reflect the real friction of transaction costs and market impact. In the real world, these costs are significant and investors should take steps to minimize them. Therefore, an efficient low-volatility equity portfolio ought to:

- maximize liquidity,
- minimize turnover, and
- maintain some semblance of economic representation.

In addition to these portfolio attributes, the construction methodology should be easy to understand and replicate, given the proclivity of passive investors for simple and transparent solutions. Our research has indicated that the current low-volatility indices all fall short on one or more of these goals, so they arguably cannot be used as core strategies.

Putting it Together

A 25% reduction in equity volatility is meaningful. If we can save that much with our dominant total portfolio risk contributor, we should have the risk budget to include higher-risk real return asset classes, right? The answer is “yes,” as we show in the third column of Table 2 (Third Pillar with Low Vol). Here, we replace half of each equity exposure with a comparable low-volatility exposure. Consistent with our empirical findings, we assumed each low-volatility equity strategy would outperform its cap-weighted counterpart by 1% per annum.⁹ We also assumed the low-volatility strategies would produce volatility levels 25% below that of the cap-weighted portfolios.

Overall, for the Third Pillar with Low Vol option, portfolio volatility declines to a similar level as the Typical U.S. Plan while expected return increases by 80 basis points to 6% per annum. To be sure, this return estimate still falls short of, and in some cases well short of, investors’ targeted returns, which are typically in the 7–8% range.¹⁰

Naturally, as with any “new” idea, there will be early critics aplenty. “It’s just a backtest… past is not prologue” or “it’s just a clever repackaging of Fama–French.” But this is not a “new” idea; Low Volatility was touted by Bob Haugen¹¹ 20 years ago. And “past is not prologue” has been used to dismiss ideas throughout history—some prematurely.

Regardless of the criticisms, low-volatility equities have important asset allocation implications for investors, especially when the traditional anchor to windward for most U.S. investors—U.S. Treasuries—sport dangerously low yields and rising credit concerns. We think it merits serious consideration.

Conclusion

While my personal experience of hurricanes is fortunately minimal, one nearly postponed my own 2006 nuptials in Baja, California. While we spent a few days fretting, the storm passed with minimal damage a day before the guests began to arrive. Not long after, like many new husbands, it didn’t take long for me to realize that life, as I knew it, had changed. Rest assured, the changes are for the better, but married life was still an adjustment for me—the big screen TV still called on Saturdays! But the miracle of TiVo and the digital video recorder eased the transition.

Today’s investors similarly are confronted with a future that will be different from everything they’ve grown accustomed to over the past 20 or 30 years. As they look to change priorities with relatively constrained risk budgets, we assert that low-volatility equities, like my DVR, can help ease the transition. By no means can they miraculously solve all of investors’ dilemmas, but they can be a simple and low cost tool to effectively broaden diversification and risk posture in the decades ahead. We look forward to sharing more of our research into this investment approach in the coming months.

[Download PDF]

Endnotes
1. We have written extensively about the rising threat of soaring debts and deficits and worsening demographics for developed markets. For example, see Fundamentals from November 2009, August
2010, and October 2011. This is correctly seen as the other side of the coin described in PIMCO’s “New Normal.”
2, See “A Complete Toolkit for Fighting Inflation,” Fundamentals, June 2009.
3, The “Typical Plan” was defined using a study of public funds published for the California State Association of County Retirement Systems (SACRS).
4. We list a toolkit of liquid asset classes and deliberately excluded hedge funds, owing to the difficulty of forecasting a return for the asset class.
5. See Tzee-man Chow, Jason Hsu, Vitali Kalesnik, and Bryce Little, 2011, “A Survey of Alternative Equity Index Strategies,” Financial Analysts Journal, vol. 67, no. 5 (September/October):37–57. The article
was selected by The FAJ Advisory Council and Editorial Board as a Graham and Dodd Scroll Award winner. The article also won the FAJ’s Readers’ Choice Award.
6. Skeptics should try this themselves with the classic 60/40 portfolio. A passive portfolio invested 60% in the S&P 500 and 40% in the Barclays Aggregate has a correlation of about 99%,
when compared with the S&P 500 over the past 10, 20, 30, and 40 years. The bonds mostly offer risk reduction, with precious little diversification.
7. See S&P Low Volatility Index Methodology: http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldata&blobtable=MungoBlobs
&blobheadervalue2=inline%3B+filename%3DMethodology_SP_Low_Volatility_Indices_Web.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application%2Fpdf&
blobkey=id&blobheadername1=content-type&blobwhere=1244081870056&blobheadervalue3=UTF-8
8. Brennan and Li (2008) posited that the low-volatility outperformance anomaly will be hard to arbitrage away because many institutional investors have benchmarking constraints to minimize tracking
error and so must own higher beta, lower returning stocks.
9. Note, we believe this is a conservative estimate; 1% is at the low end of the empirical results range and is also below the live results of popular non-price weighting methods such as the Fundamental
Index methodology and equal weighting.
10. For more on building a portfolio with a better chance of achieving expected return assumptions, please see our October and November 2010 Fundamentals, “Hope is Not a Strategy” and “The Glad Game.”
11. Former finance professor and head of Haugen Custom Financial Systems.

Tags: Absolute Returns, Bond Yields, Demarcation, Developing Economies, Discretionary Time, Girls Night, Hedging Against Inflation, Home Depot, Hurricane 1, Index Investing, Indexing, Inflation Protection, Investment Priorities, Life Changes, Married Life, Poor Job, Research Affiliates, Sharpe Ratios, Stocks And Bonds, Time Commitment, Tracking Error, Women Girls
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Dirt Economics: Demographics Matter! (Research Affiliates)

Friday, March 2nd, 2012

Dirt Demographics: Demographics Matter!

by Shane Shepherd, Research Affiliates LLC

My maternal grandparents grew up on Midwestern farms. As was typical in those days, they came from large families with seven children each. I like to think that my great-grandparents were motivated by a hard-earned grasp of “Dirt Economics”: knowing the benefits of cheap (and even free!) farm labor, they chose to have large families to help work the farm. And, given the economic realities facing a poor South Dakotan farming community, they certainly weren’t relying on their tiny savings to provide a comfortable retirement. Just as they had done for their parents, my great-grandparents hoped their children would run the family farm, put food on the table, and pay the doctor and the dry goods store bills once they were too old to work the land.

My great-grandparents intuitively understood the concept of support ratios: having just one or two children wouldn’t guarantee the retirement security they needed. Despite the economic devastation wrought by the Great Depression and the Dust Bowl of the 1930s, the underlying economic potential for their generation remained quite strong, especially following the Second World War. A growing workforce promised increasing demands for goods and services, and the production capacity to meet that demand. But a problem was forming on the horizon: Americans—my grandparents among them—stopped having so many kids, with long-term implications for the economy and investments. In this issue, we will examine how demographic changes affect portfolios in different economic environments.

The Demographic Bust

If only we found ourselves in such a fortunate situation today as prior generations did. Soaring deficits, massive debt, and worsening demographics—our frequently mentioned “3-D Hurricane”1—leave my generation in a far more dire situation than my grandparents faced. Exceedingly high debt levels and growing deficits across the developed world have attracted much attention, and rightfully so. Deficit spending is by nature a transfer of future consumption to the present. Particularly when built up across generations, excessive deficits can powerfully reduce future economic growth when those bills come due. The economic prosperity of Generation X will certainly be reduced by the need to pay back the heavy borrowing of the Baby Boomers.

Even if we could clean up our current fiscal mess with a wave of Ben Bernanke’s magic wand, our future prosperity still would decline for an even more powerful and fundamental reason. Simply put, I don’t have enough siblings. In addition to running large deficits and spending my generation’s income ahead of time, my parents’ generation forgot about Dirt Economics—they didn’t have enough children to support them in their retirement. As we moved from a predominantly single family support system to a national system anchored on Social Security, the incentives to directly replace one’s labor value vanished; instead, we shifted the burden to society as a whole. Therefore, if the Boomers begin to retire as anticipated, we won’t be able to produce enough goods and services to meet their demand! The core problem faced by the developed world today is not just the disastrous fiscal situation we see headlining the newspapers every day, but—lurking beneath the surface—our impending demographic bust.

Examining the deteriorating support ratios for the developed world puts the magnitude of this problem in context. In 1970, there were five working adults for every retiree. Today, that ratio is 3.5:1 and if the retirement age remains constant, that ratio is projected to drop below 2:1 by 2050.2 The demographics trends in Figure 1 show that, in the early 2000s, there were 10 new entrants into the workforce for every retiree; by 2020, that ratio will invert and show one new worker for every 10 retirees.

Continue reading below – Fullscreen for the better read, or download, options available at the bottom of the pane.

Fundamentals Feb 2012 Dirt Economics Demographics Matter

Tags: Debt Levels, Demographic Changes, Dry Goods Store, Dust Bowl, Economic Devastation, Economic Environments, Economic Realities, Farming Community, Food On The Table, Fortunate Situation, Great Depression, Large Families, Massive Debt, Maternal Grandparents, Matter Research, Midwestern Farms, Research Affiliates, Retirement Security, Second World War, Shane Shepherd
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Rob Arnott: There’s Always Something or Somewhere To Invest In

Friday, October 21st, 2011

Consuelo Mack WealthTrack – October 14, 2011

CONSUELO MACK: This week on WealthTrack, Financial Thought Leader Robert Arnott predicted hurricane force winds of deficits, debt, and demographics would hit the economies of Europe and the U.S. Now that they’ve arrived, what can investors do to protect themselves? Research Affiliates Great Investor Rob Arnott is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Things are not what they seem. They are worse! That is the view of this week’s Great Investor guest. For more than two years now, Research Affiliates’ Robert Arnott has been sounding the alarm bells about what he calls the “3-D hurricanes-” deficits, debt and demographics- major headwinds facing America and the rest of the developed world. He says the storms have arrived.

Arnott, a summa cum laude graduate in economics, applied mathematics and computer sciences from the University of California, Santa Barbara, is one of those rare individuals who can reduce complex financial theories and analysis to understandable and practical investment advice. For instance, he recently wrote an essay called “Simple Truisms” to guide long term investors. We will have a link on our website for you. In it, he outlined six economic truths to invest by. Here are two of them:

“Truism: GDP growth is produced mostly by young adults in their 20s and 30s.” Arnott says think emerging markets; whereas an aging population means slower growth, think the U.S. and Europe.

“Truism: earnings and dividends cannot be expected to grow faster than GDP indefinitely…” again think of the slowing economies of the developed world. Arnott’s point: can profits be far behind?

We are delighted that Arnott’s firm Research Affiliates is a sponsor of WealthTrack, but Rob is here on his own merits as a financial innovator and thought leader. Rob has pioneered several portfolio strategies that have gone mainstream including tactical asset allocation. He created one of the first global asset allocation funds using alternative markets with PIMCO. He runs their All Asset and All Asset All Authority funds. At his firm Research Affiliates, he created fundamental indexing, replacing the traditional market cap weightings of stocks in indexes with their economic weighting measured by fundamentals such as sales, dividends, and cash flow. Overall, across multiple asset classes his RAFI Fundamental Indexes have outperformed market cap ones by substantial margins over the last five years.

I began the interview by asking Arnott about his warning on WealthTrack over a year ago, about a possible double dip in the U.S. economy.

ROB ARNOTT: I think we’re probably already in it. I think the economy probably crested in June. The problem is really simple. We have a lot of GDP that’s phony GDP.

CONSUELO MACK: So explain what’s phony about our GDP.

ROB ARNOTT: GDP consists of consumer spending, government spending, capital spending, and net exports. It’s measuring spending not prosperity. So it’s measuring something that is not as important as aggregate prosperity. Now, take a family. Suppose a family measures their GFP, Gross Family Product, and they measure it based on measuring their spending. They make 50 grand. They go out and buy a flash car and borrow 100 grand to do it.

CONSUELO MACK: Those were the old days, right?

ROB ARNOTT: Yeah. But they feel much wealthier. They aren’t. They have a flash car. They have a ton of new debt. They have debt service to face and if two years later they have to sell the car, then they don’t have the car, they still have the debt to service. A nation is very much like a large family and what we have is a country where our deficit is 10% of GDP. That means 10% of our GDP is debt finance consumption; it’s not prosperity.

CONSUELO MACK: So therefore, what do you think is the real GDP? And I don’t mean subtracting inflation. So what do you think the economy, the pace that the economy is running if you took away, as you said, the debt type finance spending that we’re seeing both in the government and in the consumer level?

ROB ARNOTT: Right. Much less so in the consumer level. Consumers have been deleveraging. But if 10% of our GDP is debt financed consumption, you can subtract that and that gives you the underlying structural GDP. Structural GDP is down 11%, maybe 12 from where it was in 2007 per capita and net of inflation and it’s bottom bouncing. It’s barely above where it was at the trough in 2009. You can also subtract all government spending and that shows you the private sector GDP. Private sector GDP is also down 11 to 12% from ’07 and it’s also bottom bouncing near 2009 levels.

CONSUELO MACK: I want to talk about the U.S. stock market because so many Americans are invested in their home market as is the case all around the world. At one point you’ve said, “Don’t buy U.S. stocks because they’re priced as if we will get through this mess unscathed.” So are you still saying, don’t buy U.S. stocks?

ROB ARNOTT: I’m softening that a bit. The market has, in fact, tanked to some extent. The market is reflecting some fears that maybe, maybe some of these challenges are real. And so am I still cautious on equities? Yes.

CONSUELO MACK: And it’s specifically U.S. equities?

ROB ARNOTT: Specifically U.S. equities. Am I cautious on all U.S. equities? Not so much. The value side of the market has been savaged again and is cheap again. The growth side of the market remains very expensive. I was asked recently what my favorite long/short bet would be, and being somebody who doesn’t mind being a little proactive, I said, “Short Apple, buy B of A.”

CONSUELO MACK: That is provocative. And seriously?

ROB ARNOTT: Oh, absolutely.

CONSUELO MACK: Not in jest? This is a serious recommendation?

ROB ARNOTT: No, absolutely. Is B of A a beautifully run company humming on from height to new height? No. Is Apple a shabby company about to fall off a cliff? No, but Apple is currently priced at the number one market capitalization on the planet.

CONSUELO MACK: Right. Bigger than Exxon Mobile.

ROB ARNOTT: So the market is basically saying this company will produce the biggest profit distributions to its shareholders in the decades ahead of any company on the planet. Could that happen? Yes. Is it likely? I don’t think so.

CONSUELO MACK: “Always something to invest in.” That’s what you’ve said many times on WealthTrack and elsewhere. So when you are looking for something to invest in what are your expectations? What do you look for, especially in this new normal environment?

ROB ARNOTT: Sure. What I look for would be yields above historic norms for an asset class.

CONSUELO MACK: For an asset class. So for instance, for stocks that would be?

ROB ARNOTT: If yields are above three, they get to be a lot more interesting than when yields are two. I like to look for investments where the headwinds aren’t going to be drastic. What about emerging economies? Most of them don’t have a problem with a deficit. If they have a deficit, it’s modest. Most of them don’t have lofty debt burdens, there are exceptions, but most don’t. Most of them don’t have a demographic headwind. Quite the contrary. Sweet spot for GDP growth is young adults age 20 to 40. Is that because folks who are past 40, not you, but me. People above 40, are we not contributing to GDP? That’s not it. It’s that our contribution to GDP isn’t growing as fast as it used to. So if you go from teens to twenties, you’re looking at being a consumer of GDP to a contributor. A huge jump. Twenties to thirties. A huge jump. Thirties to forties, a smaller jump. Forties to fifties, smaller jump or for many people a slight down tip. Fifties to sixties, usually a down tip. So the contribution to GDP growth is in the young adults.
What’s happening to our young adult population? It’s shrinking as a share of the population. What’s happening in the emerging economies? It’s soaring. You have a lot of emerging economies where birthrates used to be huge, median age was 18. Half the population, teens are younger and a modest cadre of young adults and a tiny cadre of old adults. Now with falling birthrates, you have a flood of people coming into that young adult sweet spot. So the emerging economies of the world seem to me to be poised to truly emerge in a very significant way in the years ahead.

CONSUELO MACK: And so for a long term investor that demographic trend is something that you think is very important, because that’s going to be a big determiner of GDP growth. What about Africa? I mean, so Africa has a really young population. So is that not there yet?

ROB ARNOTT: That’s not helpful. That’s not helpful. You need the 20 to 40 crowd.

CONSUELO MACK: The twenties. So that’s going to happen in another ten years maybe in Africa?

ROB ARNOTT: Yeah, it’s early for Africa. It’s primetime for most of the emerging economies of the world. So emerging market stocks aren’t cheap, but they have to be part of somebody’s toolkit if they want to think seriously about investing in the coming decades, if we are in a bear market for stocks.

CONSUELO MACK: And you think we are in a bear market for stocks?

ROB ARNOTT: I think we probably are in a U.S. and European bear market. Well, Europe, obviously, but I think we are in a bear market for stocks. I think the next leg is more likely down than up. That will create some pockets of bargains in the U.S., but it will also pull down emerging market stocks, creating some real bargains. Well, that’s interesting. Emerging markets bonds. The G5 is 40% of world GDP. Emerging markets are 40% of world GDP. The G5 has 70% of world debt. Emerging economies have 10% of world debt. So the emerging economies have seven times the debt coverage ratio of the G5 and yet relative yields, the emerging economies have 3.5% higher yield. Why on earth is that? It’s because investors think back to times when the emerging markets debt was big relative to the G5 and the defaults that ensued and they think, oh, I don’t want to be part of that. But who is to say that the G5 is immune from defaults?

CONSUELO MACK: Now we know.

ROB ARNOTT: Either explicit defaults or backdoor defaults through debasing the currency through reigniting the inflation engine. So when I look at that I think, okay, lower debt burden, better debt coverage ratio, higher yield. That’s a more interesting market. And if in the coming decade the spread disappears, you’re going to have a premium yield and capital gains on top of that. Well, that’s interesting. So I look around the world and I see pockets that are mildly to moderately interesting. Commodities have come off quite a bit. They’re now getting kind of interesting. I don’t mean gold.

CONSUELO MACK: And we’ll talk about gold. We always talk about “we”, when I say on WealthTrack, because gold is almost in a separate class of its own.

ROB ARNOTT: Right, right.

CONSUELO MACK: And your view of gold is?

ROB ARNOTT: Gold has three constituencies. There are those who like gold as an inflation hedge. There are those who like it as a hedge against geopolitical shocks. There are those who like it as a hedge against government expropriation of wealth. So all three constituencies are nervous. So all three constituencies are overpaying for their protection. Now, I’m not opposed to those who want to own gold. If it helps you sleep better at night great, go for it. If it’s profitable that will be in a context of the rest of your portfolio not doing so well. So this is an investment where you buy it, A, to sleep better at night, and, B, hoping that it’s unprofitable.

CONSUELO MACK: This is your good friend, Peter Bernstein, of course, called gold an insurance policy against extreme outcomes which is one of the three categories.

ROB ARNOTT: Which is exactly right.

CONSUELO MACK: That you mentioned. And when you think of the last 11 years, the bull market in gold, it certainly has been a terrific investment.

ROB ARNOTT: It’s been awesome.

CONSUELO MACK: Considering that other assets that we mostly invest in, at least stocks, have not done well at all.

ROB ARNOTT: Or as the gold bugs are fond of pointing out, the reciprocal of that is gold has held its value. The dollar, the stock market, the bond market has not. Fiat currencies, currencies that are not backed by anything tangible, that are just pieces of paper that are backed by trust. Trust that they have value.

CONSUELO MACK: Just about all paper currencies right now.

ROB ARNOTT: Right. Fiat currencies have never, ever succeeded on a long-term basis. Now, we’ve had a great run. We’ve had a contractual fiat currency since the gold window was closed in ’71. We’ve had a de facto fiat currency since gold ownership was denied in 1933 by FDR. So we’ve had 40 years or 80 years depending on how you count it. But the gold bugs will point out that the dollar’s purchasing power measured in ounces of gold has gone down 98% since ’71, 99% since ’33. So we’ve lost all but one to two percent of the purchasing power of the dollar during this fiat currency era.

CONSUELO MACK: That’s a pretty compelling argument for gold.

ROB ARNOTT: That’s sobering.

CONSUELO MACK: It is.

ROB ARNOTT: Now of course, gold is very near all time peaks and has outperformed most commodities. So to my way of thinking, an investor thinking about inflation protection would be better served by a basket of currencies.

CONSUELO MACK: A basket of currencies?

ROB ARNOTT: Excuse me, commodities.

CONSUELO MACK: Commodities.

ROB ARNOTT: Basket of commodities. And there are a lot of funds that do track commodity indexes. And that’s one way to deal with that particular risk.

CONSUELO MACK: Looking around the world specifically as far as if you’re looking at countries, for instance. And if you want to be in a currency that you think is going to hold up, I mean, are there any countries that you think are particularly appealing at this point for you as a global investor?

ROB ARNOTT: I think the emerging economies are likely to do very well.

CONSUELO MACK: As a class?

ROB ARNOTT: Right. And I prefer not to drill down to individual countries.

CONSUELO MACK: Right.

ROB ARNOTT: Because I want the diversification of a basket. And so when I look around the world, my inclination is to say I want to invest in assets that can shrug off the impact of inflation. There are a lot of those. It’s not just the TIPS and the commodities, but they’re certainly part of the toolkit. There are emerging market stocks and bonds. There are high yield.

CONSUELO MACK: So high yield dollar denominated bonds?

ROB ARNOTT: Surprisingly, yes.

CONSUELO MACK: Really? Alright.

ROB ARNOTT: Yeah. High yield bonds are a stealth inflation hedge.

CONSUELO MACK: Explain.

ROB ARNOTT: The way it works is very simple. If you get inflation, the debt coverage ratios improve because the real value of the debt is falling. So if the business is growing with inflation and the real value of the debt is falling, debt coverage ratios improve, which means that the spreads can collapse, which means that you have a rich starting yield and capital gains. For that reason, if you go back historically and measure the correlation of high yield bonds with inflation, you find that the correlation is higher than the correlation with TIPS.

CONSUELO MACK: Oh, fascinating.

ROB ARNOTT: So it’s a stealth inflation hedge. In the even of moderate inflation, five to ten percent inflation, it can work beautifully. In the event of hyperinflation it doesn’t, of course.

CONSUELO MACK: And talk to us about TIPS. It’s been One Investment recommendation of yours in the past. You are being dubbed an inflation hawk and is that a fair—

ROB ARNOTT: That’s a fair statement.

CONSUELO MACK: Characterization? Alright. So TIPS?

ROB ARNOTT: TIPS. Expensive, lowest yields that they’ve ever had. You get a negative yield out to ten years. You get a one percent yield if you go all the way out to 30 years. That’s not very impressive. But it’s an insurance policy against renewed inflation and in that context it’s not difficult to imagine scenarios in which it could actually go to lower yields. Let’s suppose we have ten percent inflation three years hence. If that happens what is the T bond yield going to be? It won’t be ten, but it’s going to be a lot higher than 3.25. What’s the TIPS yield going to be if the treasury yield is eight or nine and inflation is ten? It could be minus one, minus two at the long end. So I’m not suggesting that as a likely scenario. I am suggesting that if we get renewed inflation that’s significant, double digit, then the TIPS will be a go-to asset and the buyers won’t care if the TIPS carry a two handle for their yield or a one handle or a zero handle. They’re going to want it because of the contractual link with CPI.

CONSUELO MACK: Right. But your inflation expectations are not double digit?

ROB ARNOTT: Actually, I would give us 50-50 odds or a bit better than 50-50 odds that we’ll see double digit sometime in the next ten years. I think the temptation to debase the currency and reduce the real value of the debt will be politically overwhelming.

CONSUELO MACK: Rob, One Investment for a long term diversified portfolio. What is your choice today?

ROB ARNOTT: My choice today would be fundamental index for emerging markets stocks, if you’re a buy and hold investor planning to hold it at least five years; if you’re a shorter term investor, look for buying opportunities and average in over the next two or three years. The reason I say that is that fundamental index has a value tilt. It pushes you more heavily into the out of favor deep value companies. With emerging markets what we find is that emerging market stocks, cap weighted, have produced slightly better returns over the last 15 years than the developed economies. Okay. You could have had a higher return with emerging markets cash.

CONSUELO MACK: Cash being?

ROB ARNOTT: Emerging markets short maturity government debt.

CONSUELO MACK: Really?

ROB ARNOTT: And so emerging markets cash investments for the last 15 years had a higher return than emerging market stocks. Well, what’s going on there? It’s that cap weighting pulls the return down by concentrating you in the two or three companies in each country that are most well politically connected, most beloved, most well known globally, and most extravagantly expensive.

CONSUELO MACK: And the biggest market cap.

ROB ARNOTT: The fundamental index weights you into companies according to the size of the business and so it takes out of favor value companies and weights them with a nice, solid weight. If they’re out of favor and come back into favor they do awfully well. So I look on deep value emerging markets as the best opportunity for a long term investor, but I do view it as an averaging in opportunity from today.

CONSUELO MACK: So you personally, are you investing in stocks right now?

ROB ARNOTT: Indirectly in modest ways. I have 100% of my personal pension in PIMCO’s All Asset All Authority Fund. So when that fund is investing–

CONSUELO MACK: Your fund.

ROB ARNOTT: Yeah.

CONSUELO MACK: Right.

ROB ARNOTT: When that fund is investing in emerging markets stocks, I’m investing in emerging market stocks. And broadly today, we’re looking at a toolkit where most things are expensive. Yields are too low across the board on a whole sweep of asset classes so it’s a great time to hunker down and have a defensive posture, have broad diversification to tamp down our risk, use that broader toolkit to pick out individual categories that might be priced off for superior returns, and to play the game that Buffett described in his twenties. He said, “The way to succeed in investing is pretty simple. Be greedy when others are terrified, be terrified when others are greedy.” When were people last terrified? Two and a half years ago. Where are they now? They’re edgy.

CONSUELO MACK: They’re getting there.

ROB ARNOTT: They’re nervous. They’re not terrified. Where were they six months ago? Don’t want to miss that last leg of the bull market. And so that’s a perfect environment for taking risk off the table. Two and a half years ago was a wonderful environment for ramping up risk aggressively. Today we’re in between those two, closer to the peak than the trough. So I look on today’s markets as a great time to start taking a little bit of risk here and there, but mostly remain very defensive.

CONSUELO MACK: Rob Arnott, Research Affiliates, financial thought leader. It is always such a treat to have you on WealthTrack. Thank you so much for doing this.

ROB ARNOTT: Thank you very, very much.

CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point: Consider the PIMCO All Asset All Authority Fund, run by this week’s guest, Rob Arnott. As Morningstar puts it the “PIMCO All Asset All Authority Fund eats market declines for breakfast.” By investing in a number of PIMCO funds, across multiple asset classes in all parts of the world, plus having the ability to go short, Arnott has managed to beat the markets and protect shareholders against market declines since the fund’s inception in late 2003. Two other pluses- it’s nearly 7% yield and Arnott has invested 100% of his pension money in the fund. That’s a reassuring commitment.
Next week on WealthTrack, we are going to have a rare double interview with bond powerhouse PIMCO’s two investment gurus, Bill Gross and Mohamed El-Erian, together from PIMCO headquarters in Newport Beach, California. For those of you who want to see our WealthTrack interviews ahead of the pack, including an extended interview with Bill and Mohamed next week, we have a new opportunity for you. Subscribers can now see our program 48 hours in advance on our website along with timely interviews exclusive to WealthTrack web subscribers. To sign up- go to our website, wealthtrack.com. Thanks for watching and make the week ahead a profitable and a productive one.

Tags: Aging Population, Alarm Bells, Applied Mathematics, Bonds, California Santa Barbara, Commodities, Computer Sciences, Consuelo Mack Wealthtrack, Financial Theories, GDP Growth, Gold, Hurricane Force Winds, Index Investing, Indexing, Portfolio Strategies, Rare Individuals, Research Affiliates, Rob Arnott, Robert Arnott, Summa Cum Laude, Term Investors, Thought Leader, Truism, Truisms, University Of California Santa Barbara
Posted in Bonds, Brazil, Commodities, Gold, Markets | Comments Off

Rob Arnott – Strategy for Volatile Times

Monday, October 17th, 2011

This week on Wealthtrack, Consuelo Mack interviews Robert Arnott, founder and chairman of Research Affiliates. He has pioneered several investment products which outperform markets with less than market risk, discusses his current strategy for these volatile times.

Source: Wealthtrack, October 14, 2011.

Tags: Consuelo Mack, Current, Interviews, Investment Products, Market Risk, Research Affiliates, Rob Arnott, Robert Arnott, Volatile Times, Wealthtrack
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Arnott: Look Outside Mainstream Stocks and Bonds (Morningstar)

Wednesday, September 28th, 2011

Arnott: Look Outside Mainstream Stocks and Bonds
Investors need to broaden their horizons and consider alternatives and tactical bets if they want to achieve respectable returns in the coming years, says Research Affiliates’ Rob Arnott.

Transcript

The 3-D Hurricane Hurtling Toward the Economy
A combination of deficits, debt, and demographics will weigh on the U.S. economy for the next 10-15 years, says Research Affiliates’ Rob Arnott.

Transcript

Arnott: Apple Pretty Darn Expensive
Research Affiliates’ Rob Arnott thinks it is unlikely Apple deserves it’s place as the largest market-capitalization company in the country and that investors shouldn’t expect outsized returns.

Transcript

Tags: Apple, Bets, Bonds, Demographics, Economy, Horizons, Hurricane, Investors, Largest Market Capitalization, Mainstream, Morningstar, Research Affiliates, Rob Arnott, Stocks And Bonds, Stocks Bonds
Posted in Bonds, Brazil, Markets | Comments Off

King of the Mountain (Arnott)

Sunday, September 18th, 2011

King of the Mountain (Arnott)

by Robert Arnott, Research Affiliates, (RAFI)

Most of us remember playing “king of the mountain” as children. The goal, often accompanied by a certain measure of roughhousing, was to summit a little hill and stay at the top while others vied to push us off and take our place.

King of the Mountain is not merely a child’s game. The U.S. stock market has been straddling a surprisingly precarious “mountain” in asset valuation for nearly two decades, resisting efforts to push us back below historical norms of valuation levels except for brief periods in 2002 and 2009.

We’ve written about the challenges over the past two years. In 2009, we described the coming “3-D Hurricane’s” soaring deficits and debts, in which we expect the post-baby-boom generations to pay down debts that we (1) promised to ourselves, (2) failed to prefund, and (3) failed to consult the generations that will be expected to honor these debts. In 2010, we addressed the consequence of soaring debt burdens in most of the developed world, as compared with the generally well-managed debt burdens of our primary external creditors in the developing world. In this issue, we explore the challenges to our lofty perch in the equity markets. Specifically, we examine the potential consequences of understated inflation and toolow real interest rates, paired with a Fed policy that seems intent on further boosting inflation and eroding real interest rates.

The Valuation Mountain

First, let’s look at how real interest rates and inflation affect valuation multiples. Some years ago, Marty Leibowitz and Anthony Bova pointed out a “hill” in valuation multiples.1 When real interest rates—which we define as 10-year Treasury bond yields less the trailing three-year average Consumer Price Index—are midrange, suggesting solid economic growth, the stock market sports a robust P/E ratio, often well above 20 times earnings.2 When real interest rates are either negative (reflecting a desire to aggressively stimulate the economy) or unusually high (reflecting a desire to rein in an overheated economy), the average P/E ratio plummets below 11.

The real-rates valuation hill is illustrated in Figure 1. It’s quite a lofty hill. Over the past 140 years, whenever real short-term interest rates have been in their 3–4% “sweet spot,” the market has exhibited a price 21 times 10- year smoothed real earnings. At real interest rates that are either lofty (above 6% in real terms) or negative, the average P/E ratio

tumbles to 11. If we limit ourselves to more recent results—over the past 50 years—we find that the peak is a little bit taller, with more tolerance for slightly lower real rates. But the shape of the curve changes remarkably little. It’s also very interesting to note that this valuation hill accounts for some 40% of the variation in P/E ratios. Real interest rates really matter to equity valuations.

It turns out that there’s another valuation hill, related to the rate of inflation. Of course, inflation generally moves in opposition to real rates: when inflation rises, often real rates fall, until the Fed decides to do something about it. In some ways, this second hill is even more powerful than the real rates hill. As we can see in Figure 2, the peak is taller, with typical P/E ratios of over 23 whenever inflation is 2–3%. However, high inflation is far more damaging to P/E ratios than high real interest rates: When trailing three-year inflation is above 6%, the P/E ratio plunges to an average of 9.4 times average 10-year real earnings.

Because real interest rates and the rate of inflation are negatively correlated, the two hills combine to create an impressive three-dimensional mountain, formed by plotting P/E ratios against both real interest rates and inflation (see Figure 3). Of course, there are some scenarios that either never happened or almost never will.

When real rates are 3–5% (moderately high) and inflation is 1–3% (reasonably benign), the average P/E ratio is 26. But it’s a sharp peak. When real rates are a bit lower (1–3%), the average P/E ratio drops to 19, a drop of more than 25%. When real rates are high (above 5%), the average P/E ratio nearly halves to 14. When inflation is a bit stronger, the average P/E ratio drops to 20; when inflation is a bit weaker, the average P/E ratio drops to 17.

The linkages are strong. The correlation between the indicated P/E ratio drawn from this valuation mountain and the actual Shiller P/E ratio is 68%. To be sure, this is an in-sample comparison, but even after adjusting for overlapping samples, we get a t-statistic of over 7 for this comparison—a strong confirmation of the validity of the data. The bottom line: over half of the variability in P/E ratios over the past 140 years can be explained by real interest rates and the rates of inflation.

Tags: 10 Year Treasury, Anthony Bova, Asset Valuation, Baby Boom, Bonds, Consumer Price Index, Debt Burdens, Developing World, External Creditors, Fed Policy, King Of The Mountain, Leibowitz, Lofty Perch, Outlook, Prefund, Rafi, Research Affiliates, Robert Arnott, Treasury Bond Yields, U S Stock Market, Valuation Levels, Year Treasury Bond
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The Trouble With Quants (Brightman)

Wednesday, August 17th, 2011

`by Chris Brightman, Research Affiliates

Oliver Wendell Holmes’ 1858 poem “The Deacon’s Masterpiece”¹ describes a perfected one-horse “shay,” a highly engineered carriage designed so that the failure of a single part could not cause an untimely breakdown. By eliminating the weakest links, the carriage performs flawlessly, at first. But the shay does not have a happy ending. It suddenly disintegrates with all the parts failing at once, leaving its rider dazed atop a pile of rubble. Holmes—the father of the eminent U.S. Supreme Court Justice— mocked the pseudo-scientific efforts of the overeducated Deacons of his day to engineer impractical structures.

In our domain, the Deacons are quants (financial engineers) and their Masterpiece is an overly complex quantitative investment strategy. The second week in August marks the four-year anniversary of the quant meltdown of 2007. While the events of 2008, including nationalization of Fannie Mae and Freddie Mac, the failure of Lehman, the bailout of AIG, creation of TARP, etc., have rightly received more scrutiny, August 2007 foreshadowed the global financial crisis and deserves more attention by today’s investors. Analyzing the underlying causes of the quant meltdown helps reveal the perils of complex quantitative strategies and highlights the difference between transparent and rules-based alternative beta strategies such as the Fundamental Index® methodology and newer optimized approaches.

The Quant Meltdown
During the week of August 6, 2007, many large and previously successful hedge funds were forced to de-lever their portfolios and liquidate commonly held securities, resulting in
simultaneous drawdowns of 30%, 50%, or worse. To make matters worse, these investments had been sold as risk-controlled and uncorrelated to the market. Khandani and Lo concluded that a “… deadly feedback loop of coordinated forced liquidations leading to deterioration of collateral value took hold during the second week of August 2007, ultimately resulting in the collapse of a number of quantitative equity market-neutral managers, and double-digit losses for many others.”² Quantitatively managed enhanced index funds experienced similar simultaneous traumas, though the magnitude of losses was lower due to the lack of leverage.

None could have forecast the precise timing of the sudden liquidation of a large trading desk that catalyzed the quant meltdown.³ But should we have been surprised that those funds failed catastrophically? After all, the quant funds of 2007 shared the same structural flaws as the highly engineered financial trading strategies that caused the stock market crash in 1987 and the implosion of Long-Term Capital Management in 1998.⁴

Inside the Black Box
To help avoid future meltdowns in our portfolios, we need to look inside the black box of quant strategies. Simply put, quants use advanced statistical methods and high frequency data to create complex financial models. With experience, skill, and some luck, a few of these models successfully forecast future security price changes. In the short term, these strategies provide consistent trading profits and gather assets into associated funds. Consistent profits can hide inherent risks, however. Most complex quant strategies have proven to be unstable. Markets evolve in response to the creation and adoption of these strategies. At first, the identified predictability in security price movements is reinforced as funds using the quant model, along with similar funds using similar models, begin buying and selling the same securities. Early success and clever marketing attracts large flows into the funds, which, in turn, drives the prices of securities held by these funds to unsustainable extremes. The result is a brittle price structure awaiting the inevitable crisis.

Leverage creates an even more toxic brew. In the years leading up to the quant meltdown in August 2007, the same models used to manage enhanced index funds (with relatively low tracking errors and high information ratios) were increasingly employed to create levered absolute return-oriented long/short funds. To facilitate the use of leverage, risk models were used to minimize country, sector, and other common factor risks. With all the risk seemingly wrung out of the strategy, ever more capital and leverage were applied.

Paradoxically, quantitative risk management was part of the problem. While risk models are useful tools for measuring risk, using models to tightly control risk is misguided and dangerous. Because no model is, or ever can be, a complete description of the complex dynamic system that is a market, all risk models fail to capture some risk. By eliminating all of the risks measured by their models, the quants transferred the risk in their funds into the areas their models could not measure and they did not understand.

Quant strategies produce remarkable profits in the early stages. But inevitably, the process becomes unstable and often ends with violent illiquidity events, such as the stock market crash of 1987, the Long-Term Capital Management-induced crisis in September 1998, and the quant meltdown in August 2007. The largest losses in those episodes were suffered by the most recent investors who were attracted by dazzling early performance records. Instead of consistent profits, the later investors were stuck with shocking losses realized during fund liquidation as investors fled from the imploding strategies.

As Harry Markowitz stated in the middle of the crisis, “…the layers of financially engineered products… combined with the high levels of leverage, proved to be too much of a good thing.”⁵

Fundamental not Quant Only four years after the last quant meltdown, over-engineered quantitative investment strategies are back. The latest incarnation is complexly optimized alternative betas. Such strategies attempt to engineer indices with the lowest possible volatility, the highest possible Sharpe ratio, or the maximum possible diversification. The more complex the engineering, the better the model performs in the backtest. As investors begin to adopt such narrow indices, early performance may be rewarding. Fund inflows will create buying and selling pressure on the same narrow set of securities. This pattern will create a brittle price structure resembling the Deacon’s Masterpiece and will set the stage for the next wreck.

Recognizing the trouble with quants, should we eschew quantitative study of security price movements and abandon risk models? Of course not! Advanced statistical methods are invaluable tools to help us understand securities markets. Likewise, risk models help us measure, monitor, and decompose the risks in our portfolios. For example, with regard to the Fundamental Index methodology, we use quantitative methods to demonstrate how and why companies with low market prices relative to fundamental measures of company size provide higher returns than companies with high market prices relative to fundamentals. We use risk models to examine whether and how value priced companies have different risk characteristics than other companies.

The Fundamental Index methodology is far less complex and therefore less risky than a highly engineered quant model. Fundamental weights are simple, logical, and stable. Fundamental Index portfolios are transparently constructed and broadly diversified. The Fundamental Index strategy uses the time-tested technique of systematic rebalancing to capture the long-term return premium offered by the market’s excess volatility.

The following passage from Holmes’ poem descries the end of the one-horse shay. But it could easily be a fitting narrative to the quant strategies during that fateful week in August 2007.

“…it went to pieces all at once, —
All at once, and nothing first, —
Just as bubbles do when they burst.
End of the wonderful one-hoss shay.
Logic is logic. That’s all I say.”

The performance of Fundamental Index strategies may break down occasionally over the long winding road to investment success, just as traditional index funds can create some nasty surprises. However, these setbacks are just that and eventually the Fundamental Index strategy’s simple and stable rebalancing process puts the portfolio back on track. That’s our logic. What do you say?

Endnotes
1. Oliver Wendell Holmes, 1890, The Deacon’s Masterpiece or The Wonderful “One-Hoss Shay”: A Logical Story, New York: Houghton, Mifflin and Company. Illustrations by Howard Pyle.
2. Amir E. Khandani and Andrew W. Lo, 2007, “What Happened to the Quants in August 2007?” Journal of Investment Management, vol. 5, Fourth Quarter
3. Khandani and Lo, 2007.
4. Richard Bookstaber, 2007, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, New York: Wiley.
5. Harry Markowitz, 2008 “The Father of Portfolio Theory on the Crisis,” Wall Street Journal, November 3. http://online.wsj.com/article/SB122567428153591981.html?mod=djemEditorialPage

Copyright © Research Affiliates

Tags: Bailout, Collateral Value, Deacons, Fannie Mae, Fannie Mae And Freddie Mac, Feedback Loop, Financial Engineers, Global Financial Crisis, Hedge Funds, Index Methodology, Investment Strategy, Liquidations, Meltdown, Nationalization, Oliver Wendell Holmes, Quantitative Investment, Quants, Research Affiliates, Shay, Supreme Court Justice
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Equity Allocations: Thinking Outside of the Box

Tuesday, July 26th, 2011

by Ryan Larson, Research Affiliates, LLC

In a classic puzzle, readers are asked to draw four straight lines through a 3 �– 3 matrix of nine dots—without letting their pencils leave the paper (see Figure 1). Most readers fail, at least initially, ending up with one dot left over. The solution requires thinking outside the box. The phrase “thinking outside of the box” has become so overused in recent years as to become trite. And yet, how many investors actually deviate from the norm with their equity allocations? Indeed, most investors follow the pack, implementing one of three “standard” strategies.

In this issue we will look at a different way of constructing the equity portfolio. We will use the concept of “active share”—a measure of how much active equity portfolios actually deviate from their benchmark indexes—as well as what active share tells us about the standard equity structure alternatives.

Equity Structure Choices The success of an investor’s overall portfolio is highly dependent on how well the equity component performs; stocks are the largest allocation in most portfolios, on average half of assets or more.¹ Therefore, paying special attention to the equity strategy decision is very important.

The three common ways to structure stock portfolios are:

1. 100% passive management, tracking a cap-weighted index

2. 100% active management, usually fundamental stockpicking strategies

3. Core-satellite—a combination of passive indexing and active management

An equity structure that entirely uses a passive cap-weighted index approach provides the market return less implementation costs. This equity structure gives you low cost and little shortfall risk relative to the benchmark, but no potential for added value, otherwise known as “alpha.” Without any alpha the passive equity structure locks in future stock returns that are unlikely to meet an investor’s return goals.²

To beat the market, investor portfolios must be different than the market. So, an investor who wants or needs to beat the market must populate his or her portfolio with active strategies because of the bets they take away from the benchmark. But exactly how active are active managers? In 2006, Martijn Cremers and Antti Petajisto of Yale University introduced a tool—dubbed “active share”—to measure how much active managers differ from the benchmark index.³

The active share measurement ranges from 0% for an index-tracking portfolio, such as an S&P 500 fund, to 100% for a fund that holds no overlap with the index, such as a concentrated active stock-picking strategy. Most active managers lie somewhere in between.⁴

Cremers and Petajisto found that funds in the highest active share quintile achieved the largest average alpha—1.1% per year net of fees and transaction costs.⁵

The average active share of this quintile of active managers is approximately 90%— that is, the typical portfolio had only a 10% overlap with the index. For the active management industry as a whole, the authors found that active share was just 30% and that the average fund returned –0.43% against the market. Net net, investors frequently end up paying high active management fees for index-like returns (or worse)!

Clearly, alpha-seeking investors should invest only in the managers with the highest active share, where they get the most compensation for taking active management risk. But the catch is that top quintile active share managers suffer from large tracking error—a statistical measure of volatility of excess returns versus the benchmark.

Although an excess return of 1.1% is attractive, studies show that both institutional and retail investors don’t have the stomach to sit through bouts of underperformance inherent in high tracking error strategies.⁶

As a result, retail investors (imitating their institutional cousins) are increasingly shifting assets into low-cost passive index funds, which have grown from 5% of equity mutual fund assets in 1996 to 15% in 2010.⁷

Tags: Active Management, Active Share, Allocations, Classic Puzzle, Equity Portfolios, Equity Strategy, Equity Structure, Future Stock, Implementation Costs, Index Investing, Indexing, Nine Dots, Passive Management, Research Affiliates, Ryan Larson, Shortfall, Stock Portfolios, Stock Returns, Straight Lines, Strategy Decision, Thinking Outside Of The Box, Thinking Outside The Box
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Sector Weights: On Average Wrong, But Dynamically Right (RA’s John West)

Wednesday, June 1st, 2011

Sector Weights: On Average Wrong, But Dynamically Right

by John West, Research Affiliates

In Marcel Duchamp’s famous 1912 painting, Nude Descending a Staircase, No. 2, the French painter captured the sense of motion by illustrating a series of images— all displayed in one frame.1 The controversial painting was inspired by Cubism’s breakdown of familiar images into multiple perspectives. But it went one better than the Cubists—who typically used static images—by adding motion, reflecting the influence of the nascent motion picture industry.2 The painting forced the observer to rethink how he or she viewed art.

Similarly, the Fundamental Index® methodology forces investors to rethink how they view portfolio returns. Investors typically dissect returns, trying to understand how much of performance is attributable to sector bets and how much to stock selection. Like Cubists, they are deconstructing reality and then putting it back together. But what if we—like Duchamp—add motion to the picture?

We are commonly asked why the Fundamental Index methodology overweights and underweights certain sectors. What’s the rationale? Why does the strategy “like” this sector or that sector? In recent years, the methodology has overweighted financials and underweighted energy, leading a rational person to conclude that holding such wrong weights surely caused performance problems. In this issue, we show such structural sector bets, in fact, don’t matter over the long term. Indeed, the Fundamental Index strategy can be wrong on average but right in the long run because of its ability to contra-trade against market fads, crashes, bubbles, and speculation. Investors need to look at the movement embodied in such strategies—not just their average holdings over a period in time.

Contra-Trading—The Great Equalizer

The markets have been through an extraordinarily volatile period the past five years, beginning with strong equity returns in 2006–2007, followed by the Global Financial Crisis (GFC) in 2008, and the subsequent Mother of All Recovery rallies in 2009–2010. Talk about a full market cycle! Within this period, sector returns have varied widely as evidenced in Figure 1.

During this period, energy and financial stocks have experienced dichotomous lives. Energy stocks jumped 10% per year and led all sectors of the market. Meanwhile, the GFC pounded financial stocks. To be fair, some financial institutions caused the GFC and were punished accordingly with the sector losing over 10% per annum. Indeed, financial stocks were the only sector to actually lose money and the only sector to underperform the S&P 500 Index during this time span. The other nine sectors all outperformed the broad market.

The FTSE RAFI® US 1000 held an average weighting of 24% in financials since it went live in November 2005, compared with the S&P 500’s average weighting of 18%. In other words, the Fundamental Index concept held an average overweight of 6%. Uh-oh. At one point in this cycle, financials registered the worst performing oneyear period for any sector going back to 1989,3 even worse than technology stocks after the collapse of the TMT bubble. With the RAFI strategy’s sizable overweight to the lone absolute and relative loser of the last five years, a logical expectation would be a big shortfall in RAFI’s performance relative to cap-weighting. In reality, the FTSE RAFI US 1000 beat the S&P by 2.3% per year, similar to the excess return as published in the original research!4

This counterintuitive result provides a good example of how the Fundamental Index concept adds value through the contra-trading embedded into the annual rebalance back to fundamental weights—that is, back to the economic footprint of the constituent companies. Figure 2 shows the FTSE RAFI US 1000’s relative financial weights (in other words, the active sector bet versus the S&P 500). Financials had a slight overweight in the FTSE RAFI US 1000 until the March 2008 rebalance, when the strategy took on an 8% overweight after bank share prices began to fall in summer 2007. In March 2009—six months after Lehman Brothers Holdings’ spectacular collapse and changes that forever changed the face of the financial services industry—financials were again rebalanced back to their fundamental weights of 25% (versus 11% for the S&P). Then the sector—left for dead in early 2009—took off. The financials weight of the FTSE RAFI US 1000 reached almost 20% more than the respective S&P 500 weight in fall 2009. As bank prices rebounded strongly, the March 2010 rebalancing witnessed a trimming of financial weights back to their fundamental scale. All told, the RAFI strategy made profits in spite of a large overweight in a sector that would have lost half its value if the weight had not been adjusted from March 2006.

There’s a lesson here. The Fundamental Index approach isn’t designed to “pick” winning sectors (or even stocks). Rather, the methodology succeeds by breaking the link between stock price and portfolio weight. A price-indifferent approach like the Fundamental Index strategy makes the link between pricing errors and portfolio weights random, not structural. The expected result? Half the portfolio winds up in overpriced stocks and half in underpriced stocks. The errors cancel.

But don’t take our word for it. Equal-weighted indexes break the link between price and weight and provide the same automated rebalancing as the Fundamental Index methodology (with a far less scalable and tougher to implement portfolio). Yet equal-weighting has had a substantial underweight to energy stocks. Why? Because the energy sector is narrow—a few mega-cap integrated oil companies dominate.5 There are only 40 stocks in the energy sector in the S&P 500; at a 0.2% weight for each, that creates an 8% target weight in the equal-weighted index. In contrast, the cap-weighted S&P 500 has a 12% weight in energy stocks, led by Exxon Mobil at nearly 3.5%, followed by very large weights in Chevron, Schlumberger, and ConocoPhillips. In spite of a large underweight in top-performing energy stocks, the S&P 500 Equal Weighted Index beat the cap-weighted S&P 500 over the last five years by the same margin that FTSE RAFI did: 5.2% versus 2.9%.6 Two independent non-price-weighted indexes—one with a huge overweight to the worst performing sector and one with a sizeable underweight to the best performing sector—beat the cap-weighted S&P 500 by more than 2%.

Conclusion

When Duchamp made art history with his notorious nude, he adopted Cubist ideas about deconstructing ideas while mocking its pretensions. He deconstructed images methodologically, but added motion and a jocular title painted along the bottom of the picture. In fact, Paris’s Salon des Independents rejected the work because the jury believed that Duchamp “was poking fun at Cubist art.”7 In reality, he laid the foundation for two new art movements: Futurism and Dadaism.

Our story is less controversial, but the idea of examining an idea—whether it’s art or investment returns—from multiple perspectives is important. We are often asked why the RAFI strategy is taking “bets” in certain sectors. The answer is the RAFI strategy’s average sector bets just don’t matter. The Fundamental Index methodology doesn’t need structural (static) sector bets to succeed. In fact, the approach can succeed even when making “wrong” structural sector bets as we have seen with financials and energy during the GFC. All the Fundamental Index methodology needs to provide excess returns over the cap-weighted index is market volatility that inevitably occurs when investor ebullience or capitulation lead to mean reversion of security prices.

The author wishes to thank Joel Chernoff, our resident art historian, and Ryan Larson, our analyst without compare, for their substantial contributions.

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Endnotes
1. See http://www.philamuseum.org/collections/permanent/51449.html.
2. See http://www.understandingduchamp.com/text.html.
3. The S&P 500 Financials returned -70% for the one-year period ending February 28, 2009; the next worst one-year return was -63% for S&P 500 Technology for the 12-month period ending September 30, 2001.
4. See Arnott, Hsu, and Moore (2005).
5. This lack of representativeness is another drawback to the equal-weighting approach.
6. We chose energy because it was the best performing sector and was a very large underweight by equal-weighting. However, the story was seen across the portfolio. Of the best four sectors that drove positive results in
the period, equal-weighting was underweight in three. Also, equal-weighting was neutral in weight in financials, meaning it derived no benefit in that sector. In total, the S&P Equal Weighting Index was unfavorably
positioned on a structural sector basis, yet beat the S&P handily.
7. See http://www.understandingduchamp.com/text.html.

Tags: Bubbles, Cubism, Cubists, Fads, French Painter, Great Equalizer, Index Methodology, Index Strategy, Marcel Duchamp, Motion Picture, Nude Descending A Staircase, Performance Problems, Portfolio Returns, Rational Person, Rationale, Research Affiliates, Static Images, Stock Selection, Volatile Period, Weights
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