Tag Archives: Research Affiliates

Morningstar’s Christine Benz On Return Forecasts

Baseball Hall of Famer and sage, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” But, as Morningstar’s Christine Benz notes, plugging in a return forecast is necessary for financial planning. Without it, it’s impossible to know how much to save and for how long. In this spirit, Benz has collected asset class return forecasts from large institutional investors and Jack Bogle, who is virtually an institution himself.

Because the forecasts are longer term, they are worth contemplating even if you can’t take them to the bank. Nobody knows what the market will do this year or next year. But it’s at least possible to be smarter about longer term forecasts. When you start at historically high valuations for stocks, such as those that exist now, it’s reasonable to assume future 7- or 10-year returns might be lower than average. In fact, the S&P 500 has returned less than 5% annualized (in nominal terms) since 2000 when it had reached its most expensive level (on a Shiller PE basis) in history. That’s only half of it’s long term average.

Below are the forecasts in table form and in bar chart form as Benz reports them. Some are nominal, and some are real; we’ve indicated which kind after the name of the institution.

At least two of the asset managers’ forecasts — GMO and Research Affiliates — take the Shiller PE seriously. That metric indicates the current price of the S&P 500 relative to the underlying constituents’ past 10-year real average earnings. When that metric is low, higher returns have tended to result over the next decade. And when it has been high, low returns have tended to result. Currently the metric is over 28. It’s long term average is under 17.

Investors should take all forecasts with a grain of salt. But when valuations are as high as they are now, it seems prudent to lower expectations.

In The Market Carnage, One Long-Short Fund Looks Impressive

Some mutual funds short stocks (bet on them to go down) at least with part of their portfolios, and Morningstar has a long-short category with 248 of them. I ran a screen on Morningstar.com’s premium mutual fund screening tool to see which of them had lost 3% or less for the year-to-date period through December 24th and also had a five-star rating, meaning a fund’s volatility adjusted return put it at the top of the category over at least the last 3 years. For the year through December 24th, the S&P 500 Index dropped 10.36% including dividends.

My return criteria were admittedly arbitrary, but hopefully not unreasonable. If a long-short fund is down 5% when the market is down 10% in one period, has the fund failed? It’s not easy to say. But I wanted to be more stringent and see if any funds that had done well against each other for an extended period of time had also weathered the storm the market has delivered recently with a better than -5% return for the year.

First of all, 38 of 248 long-short funds (or only 15%) dropped 3% or less for the year. Also, the category average return was -9.14%, only slightly better than the index’s loss including dividends. That was a little disappointing; it’s unclear that the category is earning its keep.

The fund that made the grade, dropping 3% or less and posting a five-star rating was the PIMCO RAE Worldwide LongShort Plus (PWLIX) fund. The fund has been around since late 2014, and is subadvised by Robert Arnott’s firm Research Affiliates. Arnott and others are listed as portfolio managers.

This is not a typical long-short fund whereby a research team proceeds stock-by-stock, deciding what to buy and what to short on valuation or other factors. First, this funds gets its equity exposure (both long and short) through index-tracking equity derivatives which are collateralized with a bond portfolio. The fund tries to deliver positive returns with its equity exposures, of course, but also through its bond portfolio delivering a higher return than the cost of the derivatives.

Second, this fund is normally long a worldwide index of low volatility, high yielding, and low leverage stocks and short a worldwide capitalization weighted index where stocks are ranked according to the value the market accords them. Market capitalization indexes arguably create distortions, whereby the prices of the largest stocks are unduly elevated and those of the smallest stocks are unduly depressed. That means the combination of being long an index not based on market capitalization and shorting a capitalization weighted index can benefit an investor by owning relatively cheap stocks and shorting relatively expensive stocks.

Besides low volatility stocks outperforming capitalization weighted indices in long terms backtests, the fund can benefit from what it calls “dynamically managed global equity market beta.” In other words, the fund typically has more equity exposure when markets are less volatile and less when they’re more volatile. The fund’s literature argues that these three sources of return – the low volatility equity income strategy, the actively managed absolute return bond strategy, and the dynamically managed global equity market beta strategy – are uncorrelated.

It’s likely that the correlation argument is true. After all, the low volatility equity income strategy is similar to a value approach to stock investing. The low volatility strategy was devised by a finance professor named Robert Haugen who studied the works of Benjamin Graham and took issue with the assertion of modern academic finance that one had to incur high volatility to achieve a superior return. Haugen showed that high volatility stocks were mostly what Graham called the “glamour” stocks that ran hard for a while, but wound up flaming out. Lower volatility, boring companies that didn’t capture investors’ imaginations (and then disappoint them by not fulfilling extreme expectations) plugged along and eventually produced superior returns.

The dynamically managed global market beta strategy, however, is a kind of momentum strategy. If it’s adding exposure when market are calm, it’s likely adding  exposure when they’re going up – or at least not declining and vice versa.

So the two equity strategies fight against each other to some extent – or complement each other, depending on how you look at it. One potential problem is if low volatility equity income strategies are much in favor now and, therefore, become so expensive that they don’t have much return potential over market capitalization strategies. Then the investor is dependent on the momentum-like dynamically managed beta strategy and the bonds outstripping the cost of the derivatives for return.

But maybe relying on two strategies isn’t so bad. And the fund has acquitted itself well, producing a 7.84% annualized return for the 3-year period through December 24th, 2018. That’s better than the S&P 500 Index’s 6.65% return and amounts to a performance good enough to land the fund in the top percentile of the Morningstar long-short fund category over that stretch. The fund has achieved that superior return with lower volatility — a 6.82% standard deviation of returns compared to a 9.4% standard deviation of returns for the index.

The comparison to the S&P 500 Index — the typical way Morningstar displays returns for long-short funds on its website — may work too much in the fund’s favor lately since shorting international stocks has undoubtedly helped it. But the fund has also been long international low volatility stocks, and, overall, it’s been easier to beat a global index lately than a domestic one. three years is also not a very long period of time, but we don’t have much more history on this fund. Investors will have to make due with that for now in their analyses.

Finally, while the institutional share class’s 1.28% expense ratio isn’t cheap by plain equity fund standards, it is compared to long-short funds, where shorting stocks, which can entail paying dividends, can get expensive in a hurry.

Altogether investors have a long-short option worthy of consideration in this fund, which has the potential to beat the index simply and provide an uncorrelated source of returns in a portfolio.

REITs: Slightly Better Than Broad U.S. Market, But Still Not Cheap

When I wrote an article on REITs for the Wall Street Journal in early 2017, I used a research report from Research Affiliates in Newport Beach, CA to argue that the asset class was overpriced and poised to deliver 0%-2% or so real returns for the next decade.

My article sparked a lot of mail and controversy. One reader reply underneath my article on the WSJ website said “Among equity REITs traded on stock exchanges there has literally never been a 10-year period in the history of REIT investing when real total returns averaged 0% per year (or worse) as [John Coumarianos’s] approach predicts.”

Another letter, which the Journal published as a reply to my article, from Brad Case of the National Association of Real Estate Investment Trusts (NAREIT) strangely had the exact same language about REITs never producing such a poor 10-year return as the letter written by someone of another name under the column on the website. Case’s formal, published letter went on to say, “The current REIT stock price discount to net asset value suggests that returns over the next 10 years may exceed inflation by around 8.15 percentage points per year on average.”

The decade isn’t up, but now, two years in, let’s see how things are going for REITs. Also, what’s the forecast today? Have things improved? After we assess recent returns, let’s go through the forecast again to see if things look any better now.

Not A Great Two Years For REITs

In 2017, two major REIT index funds – the Vanguard REIT Index fund and the iShares Cohen & Steers REIT Index ETF — produced a nearly 5% return each.  Considering that the CPI (consumer price index) was up 2.1% in 2017, that’s about a 3% real or inflation-adjusted return.

In 2018, the iShares fund delivered a 5.29% return through October, while the Vanguard fund delivered a 2.03% return through October. So far inflation is running at an estimated 2.2% for the year, according to the Minneapolis Fed. That means REIT real returns for 2018 are in the 0%-3% range, depending on which index you use. For both 2017 and 2018, we are a far cry from Case’s 8.15% real return forecast.

Start With Dividend Yield

The analysis advocated by Research Affiliates was simple. First, start with “net operating income” (NOI) or rent minus basic expenses. NOI a good indication of the cash flow a property or a collection of properties are delivering. Investors take this number and divide by the price of a property to determine what they call a “capitalization rate.” In effect, that resembles an earnings yield (earnings divided by price) of a stock. Mutual fund investors can substitute dividend yield of a REIT-dedicated fund.

For my original article, the dividend yield of most REIT index funds and ETFs was around 4%. Now it’s closer to 3%. The iShares Cohen & Steers REIT ETF yields less than 3.2% right now, while the Vanguard REIT Index fund lists a current effective yield of 3.23% and a yield adjusted for return of capital and capital gain distributions over the past two years at 2.13%.

Upkeep

The second component of a return forecast is a property upkeep component. Real estate requires capital – not only for the initial purchase, but also for maintaining the property. Things are always breaking and obsolescence always threatens landlords who must update kitchens, bathrooms, and other aspects of their properties. It’s true that with some property types, tenants are responsible for some upkeep and improvement, but that isn’t always the case. Research Affiliates figures 2% of the cost of the property per year, is a decent round number to use in a return forecast. Unfortunately, that wipes out most of the 3% dividend yield investors are currently pocketing.

So far, we are running at a 0 or 1% real annualized return for the next decade.

Price Change

The last component of real estate valuation and return forecasting is the most speculative. Where will properties trade in a decade? Nobody knows for sure, but Research Affiliates estimated in early 2017 that commercial property was priced 20% above its long term trend. If prices remained at that level, investors would capture the 4% yield minus the 2% annual upkeep or 2% overall. If prices reverted to trend, investors would have to subtract enough from net operating income adjusted for upkeep to bring future returns down to 1.4%.

Currently on the Research Affiliates website, the firm forecasts REITs to deliver a 2% annualized real return for the next decade. That’s about where the forecast stood at the beginning of 2017. It’s worth noting that although that’s a low return, it’s actually a better forecast than the firm has for U.S. stocks, which it thinks won’t deliver any return over inflation for the next decade.

Gut Check

It’s often useful to take multiple stabs at valuation. So, in the spirit of providing a gut check, I supplemented this dividend-upkeep-price analysis with a simple Price/FFO (funds from operations) analysis. REITs have large, unrealistic depreciation charges, rendering net income a mostly useless metric. FFO, which adjusts net income for property sales and depreciation is a more accurate cash flow metric. FFO isn’t perfect either because it doesn’t account for different debt loads of different companies and because it doesn’t account for maintenance costs, but it’s a uniform metric that almost all REITs publish.

Of the top-20 holdings of the Vanguard Real Estate Index fund VGSIX, Weyerhaeuser and CBRE didn’t publish FFO metrics. The average of the other 18 companies was 20. That’s a pretty high multiple for REITs, which are slow growth stocks.

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.

A Recession Says Nothing About Future Stock Returns

(Thanks to Morningstar’s John Rekenthaler for including one of my emails to him in a column consisting of reader reponses while he tended to his wife who, as he reports, suffered a fainting spell. We wish both of them well, of course.)

Do we need a recession or another credit event similar to 2008 to tell us stocks are overpriced and cause them to tumble? John Rekenthaler of Morningstar seems to think so. I sent him an email in response to an article he wrote doubting the verdict of recent bubble-callers like GMO and Research Affiliates. I said stocks were objectively expensive (using the Shiller PE), and that meant future returns would likely be low.

But John thinks that a turn in the economic cycle will determine a downturn in the stock market, and tell us, after the fact, if stocks are overpriced. Since we don’t know when that will occur or what it will look like, we must remain agnostic as to the future returns of the stock market. As he responds to my email in a new article:

“One of these years the economic cycle will turn, thereby making projected corporate earnings wildly overstated rather than moderately so. Stocks will get crushed. If that happens in 2018 or 2019, then equity prices will indeed have been high, and returns will indeed be low. If the economy holds out until 2020 or longer, though, then today’s values should look reasonable.”

Unfortunately, while stock markets tend to tumble when the economy goes South, since the Great Depression there’s scant evidence that single recessions tell us anything about how stocks are priced or indicate anything about their future 10-year returns. For that all-important forecast, one must consult starting valuations more than recessions or moment in the economic cycle.

Consider the 50% decline the S&P 500 Index suffered from 2000 through most of 2002. The recession in 2000 was minor. In fact, it didn’t’ even meet the standard definition of two straight quarters of GDP contraction. GDP contracted in the second quarter of 2000, then again in the fourth quarter of that year, and never again.

Did that recession warrant a 50% price reduction in stocks? Did it somehow prove that stocks were overpriced? Or were stocks just wildly overpriced to begin with, as the Shiller PE hit 44 in early 2000?

The point isn’t that we may or may not have a recession over the next 2, 3 or 5 years. The point is stocks are at a Shiller PE seen only twice before in history – 1929 and the run-up to 2000. Come recession or not, over the next decade investors in the S&P 500 will capture a 2% dividend yield. They may also capture 4%-5% earnings-per-share growth. That puts nominal returns at 6%-7%, which isn’t bad at all. Unfortunately, the third component of future returns consists of where the future PE ratio will sit. Will the Shiller PE maintain itself above 30? Or will it contract to something resembling the historical average of nearly 17? Even if that average is outdated, is the new norm 32? Or is it more like 20 or 22?

Whether a recession comes within the next 5 years or not has little to do with these questions. And though it may send stocks down for most of its duration, it ultimately will have told us nothing about longer term returns compared to how much starting valuation can tell us. In fact, the two features of the Shiller PE are that it’s based on a prior decade’s worth of earnings and is pretty good at forecasting the next decade’s worth of returns. It’s not based on short-term earnings, and it’s not good at forecasting short-term stock returns. A recession doesn’t matter one whit insofar as it’s a typical part of a full cycle that the Shiller PE aims to capture in its earnings calculation and in its stock return forecast.

It’s possible we might wake up in a decade to a 32 Shiller PE. And it may have remained there all along, or it may have arrived there again as the result of any number of gyrations. The question is what should financial writers be telling their readers (and financial advisers telling their clients) about that possibility?

See A Bubble? Get Out Of The Way.

In early March, we reprinted an article I wrote for Citywire on bubbles. That article focused on an academic paper called “Bubbles for Fama” by Robin Greenwood, Andrei Shleifer, and Yang You on spotting bubbles. It tried to provide a definition that would satisfy proponents of the efficient markets hypothesis who doubt that bubbles exist.. The authors noted that 100% run-ups of asset prices in a two-year period resulted in a heightened probability of a subsequent crash.

Early this week, Research Affiliates weighed in on which assets might be in a bubble today, citing another research paper by Greenwood and Shleifer discussing how investors behave with strong “extrapolative tendencies.” In other words, investors anticipate strong returns after strong return periods, when future returns are likely to be lower, and also anticipate weak returns after weak returns periods, when future returns are likely to be higher.

What’s A Bubble?

But before we get to that argument, Research Affiliates founder, Robert Arnott, and his colleagues, Shane Shepherd and Bradford Cornell try to keep the definition of a bubble simple. They argue a bubble is a “circumstance in which asset prices 1) offer little chance of any positive risk premium relative to bonds or cash, using any reasonable projection of expected cash flows, and 2) are sustained because investors believe they can sell the asset to someone else for a higher price tomorrow, with little regard for the underlying fundamentals.” (Can you say Bitcoin?) There are bubbles now in technology stocks and cryptocurrencies, according to Research Affiliates. Overall, the U.S. stock market is very expensive too.

The authors are aware that modern academic finance would find their definition lacking. Adherents of the efficient markets hypothesis think “[t]he market’s willingness to bear these risks {of high prices relative to reasonable projections of cash flows] varies over time. . . . .high valuation levels don’t represent mispricing; the risk premia just happen to be sufficiently low so as to justify the prices.” Of course, if risk premia or required returns can vary so widely, what’s the difference between and efficient market and an inefficient one?

More realistic observations come from behavioral finance which shows that investors bring their own psychological baggage to markets even when they know and understand formula-based valuation models. Moreover, Greenwood and Shleifer show that investors are so tied to recent price trends that they anticipate higher expected returns after big price runs when valuation models anticipate subpar returns, and lower expected returns when valuation models anticipate robust returns. Moreover, investors bet accordingly, putting more money into stocks after they have gone up, and withholding it after they’ve gone down.

What Can Investors Do?

If you’ve spotted a bubble, the temptation is to short it. But that turns out to be very difficult, despite the success of the hedge funds depicted in Michael Lewis’s The Big Short.  Arnott et. al. recount the story of Zimbabwe at around the time of the financial crisis. At first, when Zimbabwe’s currency crashed, the stock market soared. Then the stock market crashed as the currency continued to crash more. And finally, when the currency collapsed, so did the stock market for good. The problem with having shorted stocks in this case is that their initial run up might have bankrupted you. And even when asset prices don’t react to a currency failure the way Zimbabwe stocks did in 2008 by shooting up initially and then cratering, bubbles can keep getting bigger and bigger. Not everyone facing a bubble has the advantage that the hedge funds doing “the big short” had — knowledge of when most of the adjustable rate mortgages issued would reset at higher rates, causing most borrowers saddled with them to default. A bubble might be easy to spot, but it’s hard to trade.

Instead of shorting, the easiest thing to do when you spot a bubble is to avoid it. Nobody needs to own Bitcoin or cryptocurrency. Also, nobody needs to own any technology stocks right now. Moreover, there are many stock markets around the world cheaper than the U.S. market. The cheapest stock markets around the world are the emerging markets, according to both Research Affiliates and Grantham, Mayo, van Oterloo (GMO) in Boston. It’s true EM stocks often come with an extra dose of volatility, but their valuations are lower than that of the U.S stock market. Also, none of this means those are the only stocks you should own though. There are ways to mitigate overvaluation of U.S. stocks such as with an ETF that owns more of the cheapest ones like the iShares MSCI USA Equal Weighted ETF (EUSA) or the PowerShares FTSE RAFI US 1000 ETF (PRF). But when things are expensive, it’s fine to stay away from them.

Even being relatively conservative by overweighting emerging markets stocks rather than shorting U.S. stocks entails some “maverick risk,” as Research Affiliates calls it. This is sometimes called “career risk,” because clients will fire and advisor or asset manager who deviates too much from a benchmark or his peers for too long a period of time. Investors must be honest with themselves about how much maverick risk they can tolerate, and advisors must be careful not to exceed their clients’ tolerance for maverick risk.

Most of all, when contemplating asset prices and prospective returns, remember that your mind may be playing tricks on you when you expect unusually large or unusually small returns. Don’t extrapolate recent return history into the future. The future might hold the opposite scenario from the recent past.

A Day At The Beach, Part 2 — Global Asset Allocation

See Part 1 – Here

In this second installment relating my trip to the Research Affiliates Advisor Symposium in Newport Beach, CA, I will discuss the firm’s second major line of research, which involves the appraisal of global asset classes. The firm manages the PIMCO All Asset (PAAIX), and All Asset, All Authority (PAUIX) funds. These are global asset allocation funds that seek the maximum real return, often by emphasizing non-mainstream asset classes. The funds own stocks, bonds, commodities, and currencies through underlying PIMCO funds. Over the long haul, the goal of All Asset is to beat TIPS and inflation by 5 percentage points, while the goal of All Asset, All Authority is to beat the S&P 500 and inflation plus 6.5 percentage points. Research Affiliates thinks these inflation goals are tall orders currently.

For example, a glance at the asset allocation part of the firm’s website shows that U.S. stocks are poised to deliver no return over inflation over the next decade. Stocks from developed countries, by contrast, are expected to deliver a little more than a 4% annualized real return, and those from emerging markets are expected to deliver nearly a 6% annualized real return. Besides emerging markets stocks, no asset class, save private equity, is likely to deliver more than a 5% real return.

First, Chris Brightman, CIO of Research Affiliates, led the attendees through the firm’s asset class returns. Bonds returns, of course, follow starting yields closely throughout history with a correlation of 0.96 between starting yields and future 10-year returns. Similarly, strong correlations exist globally.

In equities future returns follow starting earnings yields, using the inverse of the CAPE Ratio (Price relative to the past decade’s worth of real average earnings). The correlation between starting earnings yields and subsequent 10-year returns is 0.75 since 1926, though admittedly, returns have been higher lately. Again, similar correlations exist in other countries.

The current level of the CAPE implies a roughly 80% overvaluation of stocks. Other metrics, including Market Capitalization relative to GDP, Tobin’s Q, and Hussman’s PE show similar overvaluation. There’s hardly a way to look at US stocks, and not conclude that they are overpriced. Among Western developed countries, only the UK appears as if it is priced to deliver a real return of more than 5% for the next decade.

 

A Demographic Interlude

During his talk, Brightman speculated on why valuations seem to be higher than in the past. He remarked that macroeconomic volatility is lower today than it’s typically been in an agrarian economy where bad weather can wreak economic destruction. There are arguably lower risks in a post-industrial economy, and perhaps this is properly reflected in lower return prospects. There is also a greater ease in investing with the advent of index funds and ETFs; it’s easier to obtain a more diverse, lower-cost portfolio.

Brightman also made a demographic observation – an increasing percentage of older people in an economy tends to lower productivity growth. This, in turn, has an influence on real rates of return. Brightman used the example of teenagers who consume a lot and produce nothing. But when teenagers get to be, say 25 years old, the rate of change in their productivity from the time they were 15 is extremely high. Similarly, there is a great rate of change in productivity from the ages of 25 to 35. But then there is a lower rate of change from 35 to 45, and after 45 there is no difference in growth. Then, when adults become old, they revert to being teenagers again – consuming a lot, but producing little. The difference is that teenagers have parents and senior citizens have assets – and that’s why asset prices are higher and return prospects lower.

All of this means that the U.S. enjoyed a period of superior growth as the baby boom generation matured and entered the work force. In other words, the post-war demographic trend flattered the superior growth of that period, and without similar demographic trends, the growth likely can’t repeat. It’s possible that stocks can deliver higher returns if earnings-per-share growth increases, but for three or four decades the ratio of profits to GDP has been growing. Brightman was skeptical that corporate profits could continue growth faster than the economy because, if that trend continued, it would likely violate rules of social equity. It’s likely that corporate profits will not grow faster than GDP from this point.

 

Non-Mainstream, Better Beta, and Rebalancing

Investors have a few options to boost returns. First they can consider non-mainstream stocks and bonds. Emerging markets, as previously mentioned, are poised to deliver higher returns than financial assets from developed countries. In fact, Rob Arnott, in his talk on after-tax returns, volunteered that one-third of his liquid net worth is in emerging markets equities. Second, investors can potentially extract greater returns from low-returning asset classes by using smart beta strategies such as fundamental indices. Capitalization weighted indices can’t deliver excess returns, and active management cannot collectively beat the market. Third, investors can rebalance diligently across asset classes instead of buying and holding, which tends to overweight recent winners. “Tactical over-rebalancings,” as Brightman puts it, can help boost returns.

Brightman’s three recommendations make me think investors need good advisors now as much as ever. Individual investors aren’t always comfortable choosing non-mainstream asset classes. They also aren’t as able to pick smart beta funds as they are plain index funds. Moreover, investors aren’t likely to pick the best smart beta funds, which, as Brightman’s colleague FeiFei Li noted, are not always characterized by the lowest expense ratio. Last, advisors are probably better equipped to accomplish the rebalancing that Brightman thinks will be a significant part of a successful investor’s future returns.

A Day At The Beach, Part 1

I’ve just returned from the Research Affiliates Advisor Symposium in Newport Beach, California last week. If the cloudy and sometimes rainy weather disappointed some of the attendees, the conference itself didn’t. As I reflect on it now, it stands as one of the finest investment conferences I’ve attended. This will be the first in a three-part series on the conference.

The argument against traditional indexing

Before I talk about the conference, a few words about Research Affiliates are in order for readers who aren’t familiar with the firm. Research Affiliates is the company of Robert Arnott who is the author of influential papers on investing and a former board member of the Jounral of Portfolio Management. Arnott arguably devised the first “smart beta” stock strategy which he calls the “fundamental index.” Instead of ranking stocks in an index based on market capitalization, which is how most index funds function, the fundamental index ranks them on four economic factors of the stocks’ underlying businesses – sales, cash flow, dividends and book value. In other words, the fundamental index or “RAFI” (Research Affiliates Fundamental Index) “breaks the link,” as Arnott puts it, between a stock’s rank in an index and its market capitalization or price. In fact, that’s what all smart beta strategies do; they are all based on some newly devised “beta” or index that doesn’t rank stocks based on their price or market capitalization. I like Arnott’s approach because it forces investors to think of stocks as ownership units of businesses and to rank stocks based on characteristics of their underlying businesses.

Products that use the fundamental index include the PowerShares FTSE RAFI US 1000 ETF (PRF) and the PIMCO RAE Fundamental PLUS Fund (PXTIX). Other funds apply fundamental indexing to foreign stock markets. Arnott’s insight that capitalization weighted indexes necessarily give an investor more exposure to more expensive stocks and his research into other forms of index construction started the smart beta revolution. Other “factors” or characteristics of groups of stocks that could help those stocks beat the market – namely small and value —  were identified in a famous paper by Eugene Fama and Kenneth French. While Dimensional Fund Advisors took its bearings from the Fama/French research and built funds with capitalization weighted indexes that it tilted toward small-cap and value stocks, nobody created an alternative index or helped create funds that were invested in one until Arnott.

One award-winning academic paper has argued that the fundamental index has a “value bias” making the PowerShares fund’s S&P 500 Index-matching performance over the past decade, when value has underperformed growth, striking. (Arnott also classifies his index as value-oriented on the smart beta portion of the Research Affiliates website.) The PIMCO fund has outperformed the index by more than 300 basis points annualized, but it’s structured differently than the PowerShares fund. The PIMCO fund gains exposure to the fundamental index through a derivative, which it colateralizes with a bond portfolio. So it has two sources of return – the fundamental index and the bond portfolio that PIMCO manages in an effort to overcome the price of the derivative.

Since the development of products using the fundamental index, other funds with other “factors” have hit the market. Along with plain capitalization weighted index funds, smart beta funds have been attracting assets in droves while traditional active managers mostly bleed capital. But there aren’t as many factors that can consistently beat capitalization weighted indices as marketers might have you think. The “factor zoo,” as Research Affiliates calls it, may be well populated, but only a few species are worth much. Those are value, size, income, momentum, low beta, and quality. In some of its papers, Research Affiliates isn’t even sure “quality” is a legitimate factor, although the firm includes it in its factor appraisals on its website.

Not All Factors Are Equal — Or Always Well-Priced

The question about which factors might be overpriced comes from an argument about data mining. Most factors reflect data mining or observance of a one-time bump in valuation that isn’t sustainable. This has caused a public argument between Research Affiliates and Clifford Asness of AQR Management. If illegitimate factors are the result of a one-time or random bump in valuation, legitimate factors that have persistence can get expensive too. Furthermore, those factors can be embraced or shunned – in effect, timed — based on their relative historical valuations. By contrast, Asness thinks investors are better off sticking with a factor or two they like rather than trying to time them.

Parts of the conference addressed the valuations argument. Research Affiliates thinks momentum and low-beta or low-volatility strategies are expensive. That makes sense given that some investors have driven up the prices of Facebook, Google, and Amazon, and others have sought stock exposure with lower volatility in the aftermath of the financial crisis.

Most value strategies, on the other hand, are relatively cheap. They have suffered as Facebook, Amazon, Apple, Netflix, and Google have propelled growth and momentum indices higher in recent years. But investors might be wrong to choose the factors that have performed the best. Research Affiliates Head of Investment Management, FeiFei Li, gave a presentation showing among other things that choosing the worst performing smart beta factors can lead to better performance than choosing the best performing ones. Valuations are predictive of future returns. In other words, contrarian smart beta investors looking for a “reversion to the mean” might overweight value over momentum based on how each factor is priced relative to its history on the Research Affiliates website.

Li also argued that investors should look at how smart beta funds implement their strategies, because implementation can have a much greater effect on returns than the expense ratio. In particular, high turnover, low weighted-average market cap, and a low number of holdings can be warning signs to investors that a fund isn’t implementing its strategies in the most cost-effective ways.

Morningstar’s Director of Global ETF Research, Ben Johnson, followed Li’s talk with some similar themes. Johnson argued that re-framing factor investing as an evolution of active management was useful. Many traditional stock pickers use factors that characterize ETFs, just not as systematically and mechanically. Johnson also warned investors to be wary when funds with similar factors are introduced at once. That can be an indication that a factor has had a run that’s probably not repeatable.

In my next installment, I will report on the portions of the conference that were concerned with global asset allocation and asset class valuations.