Tag Archives: Rob Arnott

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.

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.

The Problem With Indexing

Indexing your investments is a good way to increase your chances of doing better than average. Most active investors trying to pick winning stocks (and avoid losing ones) don’t beat the index. Those who do are hard to identify ahead of time. Once you think you’ve identified a market-beating manager, they often allow their fund to get too big, which typically reduces their chances of repeating their past success. And sometimes they’re on the cusp of retirement. Or they’ve lost analysts who’ve helped them be great. In other instances, you might be correct in thinking they can outperform over the long term, but you’re about to capture one of their fallow periods. Nobody ever said this game was easy.

Yet, there are problems with indexing too. “Indexing” generally means following what’s called a “capitalization weighted” index. That means the rank of the stock in the index is determined by how much the stock market values it. Market capitalization is the total shares of a stock outstanding multiplied by the price per share. But is taking the stock market’s verdict about where a stock should be ranked in an index reasonable? Many people think it isn’t. After all, you necessarily own more shares of the most favored and possibly expensive stocks in a capitalization weighted index.

When the first index fund – the Vanguard 500 Index Fund – came to the market in the early 1970s, academic finance was dominated by the notion that the market prices stocks properly – or accurately, based on available information – at all times. That made it seem reasonable to rank stocks by how the stock market says they should be ranked.

But there’s a case to be made that ranking stocks based on their underlying companies’ economic fundamentals such as sales, earnings, dividends, and book value might also be reasonable. And if stock markets don’t always set prices properly, if they are sometimes the victims of emotion gripping their participants, maybe focusing on economic fundamentals of the businesses is a smarter approach to indexing. And, after all, if you rank stocks based on companies’ underlying economic fundamentals, you’re arguably not showing any disrespect for markets. You might just be elevating the markets for companies’ goods and services over the market that trades those companies’ stocks.

An easy way to “break the link” (as Rob Arnott, founder of fundamental indexing, puts it in describing all “smart beta” strategies) between market capitalization and index rank of a sock is to start with a capitalization weighted index, but then rearrange it in a way that equally weights the stocks. No attention to underlying economic fundamentals needed.

This is the subject of a new paper published by Standard and Poor’s. First, the paper documents the outperformance of equal-weight indexes compared to their capitalization weighted equivalents. According to the paper the S&P 500 Equal Weighted Index has outperformed the S&P 500 Index by 2.1 percentage points. Moreover, this outperformance or “alpha” exists in international markets as well.

How much money is 2 percentage points annualized? It can amount to $50,000 in a scenario that’s not difficult to imagine for an ordinary investor. For example, if you invest $5,000 for 25 years and earn 5% annually on the investment, you’ll wind up with just under $340,000. If you invest the same amount for the same time frame, but earn 7% annualized instead of 5% annualized, you’ll wind up with just under $390,000.

The most obvious reason for the outperformance of the equal-weight index is its greater exposure to smaller stocks. The plain S&P 500 Index is concentrated at the top. Only 10% of the names – 50 stocks – account for nearly one-half of the index’s total weight, and the largest 30% of stocks – the top 150 – account for 75% of the total weight. Conversely the smallest 40% — the bottom 200 stocks – account for only 10% of the index’s total weight.

An equal-weight index will elevate the exposure to the smaller stocks in the index, and this “size bias” explains a “considerable portion of the S&P 500 Equal Weight Index’s long-term returns,” according to the paper. Another smaller part of the explanation is related to the fact that the equal weight index undergoes periodic rebalancing. This means that stocks that have done well are periodically sold and stocks that have done poorly are purchased to keep the fund’s allocation equally weighted to the 500 stocks. So equal weighted indexes have a kind of “anti-momentum” strategy. And while momentum is viewed as a legitimate factor that can beat a plain index, so does an anti-momentum strategy. In fact, performance of the equal weighted index relative to its capitalization weighted counterpart can indicate how momentum is faring overall in markets in a given period, according to the paper. When momentum is doing well, the equal weighted strategy tends not to do well, and vice versa.

Another feature of an equal weight index is how it treats the sector components of the index. During the technology bubble of the late 1990s, technology stocks began to overwhelm the index in the sense of becoming a larger and larger component of it. And although an “equal-weight index effectively allocates to each sector in proportion to the number of stocks held in that sector,” according to the paper, this is enough to mute the bad or overwhelming effects that a sector run-up can have.

Overall, the evidence suggests that an equal-weighted index captures a greater share of the stocks that achieve above-average returns. This doesn’t mean such a fund should be the only stock holding in a portfolio. For example, it can complement trend-following or relative strength strategies, helping to increase a portfolio’s volatility-adjusted returns when used that way. An equal-weight strategy can also mute the tendency of a low volatility strategy to go through periods of underperformance.

Although the paper doesn’t characterize a capitalization weighted index this way, its analysis begs the question of whether such an index is itself a kind of a momentum strategy. In any case, investors should be mindful of the problems inherent in plain capitalization weighted indexes especially at a time when indexing is garnering so many investor dollars. Capitalization weighted indexer will do fine over time, if investors can stick with the approach through thick and thin. But, at some point, they might wonder why they didn’t consider alternatives.