2008 in Review: Every Rule Has an Exception

By Rob Arnott

JANUARY 2009 Read Time: 10 min

The year 2008 was a remarkable year in the capital markets. The S&P 500 Index, which posted its worst year since 1931, was only one of many disappointments, as virtually all risky asset classes produced breathtaking losses. Hedge funds failed to hedge (not to mention that one fund had pulled a $50 billion fraud for the ages). The strategies of many of the best active stock pickers of the past two decades massively underperformed the plunging indices. Confidence in anything—for institutions and individuals alike—vanished. More than anything else, 2008 proved to be the exception to many of the investment “rules” once thought to be cast in stone. In this issue we review this extraordinary period through the dual lenses of our global tactical asset allocation (GTAA) and Fundamental Index™ strategy focus areas with an eye toward the future.

Global Tactical Asset Allocation
The challenges and opportunities facing asset allocators were self-evident in 2008. Over the past 12 months, most asset classes experienced their worst returns ever or, for those with a long enough history, since the Great Depression years of the 1930s. Indeed, this misfortune fell on 10 of the 16 key asset classes we follow.

Within this overall dreadful 12-month stretch were three distinct subperiods as shown in Figure 1: the conventional bear market of January through August, the “take no prisoners” market of September and October, and the “sorting through the carnage” market of November and December.

In Stage One, the first eight months of 2008, in contrast to the later blood-letting, fully 7 of the 16 asset classes managed to post positive returns. Among those that escaped losses were Treasury Inflation-Protected Securities (TIPS), emerging market bonds, commodities, and core bonds. None of the equity categories produced positive returns; losses ranged from –3% to –2%. An equally weighted portfolio of these 16 assets classes would have returned –2.2%—a loss but hardly a debilitating impairment of capital.

Then came Stage Two, the September/October 2008 crash, which changed the picture drastically. Simply put, these two months were a Take-No-Prisoners market. All 16 asset classes fell. That had not happened before in any single month, let alone any two-month span in the past 20 years. Furthermore, the losses were astonishing: 13 of the 16 asset classes lost more than 10%, and half lost more than 20%! For 12 of the 16 asset classes, their performance was the worst two-month stretch of performance in the past 20 years or more. From TIPS to emerging market equity, asset classes were devastated. The benefits of diversification and relative value decisions were a no-show.

This lockstep free fall had a remarkable effect on most asset allocation strategies. Students of Markowitz’s efficient frontier can tell you that the diversification effect is mathematically captured through the correlation coefficient. In the 20 years ending 2007, the average cross-correlation of the 16 asset classes was 0.27.1 In 2008, the average more than doubled; for the year, these assets were highly correlated at 0.58.2 And, during the take-no-prisoners market, the correlation often seemed to approach 1.00!

But September/October opened up the door to recoveries in November/December 2008. Crises bring opportunities. Indeed, the global meltdown of fall 2008 produced, in our opinion, severe price dislocations in several markets. Many areas of the bond market sold off more relative to their historic risk profiles than equities did. Markets that were “four sigma events” for stocks were “eight sigma events” in other markets. Some categories appeared to be pricing a deep depression, whereas equities were pricing only a moderate recession. Consider the following:

  • Emerging Market Bonds. On October 24, 2008, the spread offered by emerging market bonds over U.S. Treasuries was 9.6%—the widest spread since the 11.6% witnessed in the Long-Term Capital Management sell-off of August 1998. What makes this immense risk premium remarkable is that the asset class is now 60.3% investment grade, whereas back in 1998 it was only 10.8% investment grade!3
  • TIPS. By the end of October 2008, the 20-year TIPS yield was 1.39% lower than the nominal 20-year Treasury yield on October 27, implying an annual inflation of 1.39% for the next two decades. Such a level of inflation has not been seen since 1926–1945, an era encompassing five years on the gold standard, followed by the Great Depression and World War II!
  • Convertibles. Driven by the severe unwinding of the entire convertible arbitrage hedge fund strategy, the Merrill Lynch Convertible All Qualities Bond Index fell more than the S&P 500 during the September/October implosion. Granted, the conversion features were essentially worthless, but these securities are still bonds that carry all of the benefits of being higher in the pecking order in the capital structure!

Following these wild mispricings, as the deleveraging took a pause long enough for investors to reassess relative value, we did indeed see many asset classes recover handsomely in November/December 2008. Eight of the 16 asset classes produced gains, which would have caused an equally weighted portfolio to produce a gain of 1.5%. Interestingly, this rebound was not led by the stock market. The S&P 500 actually finished 12th out of the 16 asset classes during Stage Three.

A model-driven GTAA strategy is designed to capitalize on the opportunities created by these types of price dislocations. Institutional investment committees aren’t equipped to make the necessary asset allocation decisions. The contrarian strategy—moving into distressed assets when they are most feared—runs counter to human emotions and confronts people with the dreaded “maverick risk.” These issues are particularly problematical when out-of-mainstream “niche” asset classes are involved. These classes are typically the first to be abandoned in a period of market duress. Perhaps this is why diversified portfolios tend to outperform as the economy comes out of periods of severe market stress. Figure 2 displays the returns of the 16-asset-class portfolio (equally weighted) compared with the returns of a traditional 60% S&P 500/40% Barclays Capital Aggregate Bond portfolio in the three years subsequent to three financial crises of the past 20 years.

We think 2008 has provided several key lessons on asset allocation. First and foremost, 2008 taught us that extrapolating historical return characteristics, even very long term characteristics, is dangerous. Every rule has an exception. However, to let the massive meltdown in September and October 2008 serve as a primary guide to our future decisions would be equally dangerous; this market was nothing if not extraordinary. Rising correlations may be part of an increasingly intertwined global financial community, but a doubling of the average cross-correlation is extreme and unsustainable. Furthermore, the three-stage analysis shows that active asset allocation provided opportunities before and after a dreadful stretch in the market. We think this characteristic will continue: Assets will be repriced to deliver a “fair” return for the corresponding risk. That truism combined with a wealth of low-hanging fruit bodes well for advocates of GTAA.

The Fundamental Index Approach
The Fundamental Index approach produced mixed results vis-à-vis capitalization-weighted indexes in 2008. The published FTSE RAFI® series witnessed relative performance successes (there were no absolute victories in 2008!) in Japan, Australia, Canada, international small companies, and the emerging markets. However, since the launch of the RAFI methodology was commercialized in late 2005, 2008 marked the first and only calendar year of shortfall, albeit slight, by a global all country RAFI strategy relative to a global, all country cap-weighted index. The RAFI strategy posted a decline of –42.5% versus the MSCI All Country World Index of –41.9%, a slight shortfall of 0.6 percentage points, following outperformance of 6.0% and 2.0% in 2007 and 2008, respectively. Combining the entire post-2005 experience, the global, all country Fundamental Index strategy has outperformed the MSCI World by a very respectable 1.8% annualized over three years.4

Unquestionably, the largest drag on the global Fundamental Index strategy was the U.S. market. There will always be exceptions to the rule—outliers in statistical speak. Last year, that outlier was the United States. The FTSE RAFI US 1000 Index trailed the S&P 500 by nearly 3 percentage points in 2008. As we have commented, the Fundamental Index approach typically enjoys a tailwind boosting performance when value stocks are winning in the market. Thus, many followers of the Fundamental Index strategy were surprised by the U.S. shortfall, because value stocks seemed to outperform in late 2008. The Russell 1000 Value Index outperformed the Russell 1000 Growth Index by 159 basis points. However, many observers would disagree with the notion that 2008 was a value year. As shown in Figure 3, the S&P/Citigroup Growth and Value Indexes showed the opposite—the S&P 500/Citigroup Value underperformed the Growth index by 430 basis points.

A possible explanation for these differences is the rebalancing methodologies used by the three cap-weighted index providers. Frank Russell Company rebalances at the end of June; S&P/Citigroup, in December. At mid-2008, the Russell Growth naturally gravitated toward those stocks showing the best growth prospects over the past 12 months, namely, energy and materials (on the heels of the commodity boom.) The Russell Value, meanwhile, would have picked up some of the sectors showing less promising recent operating results and cheaper valuations—probably, the consumer discretionary, health care, and financial sectors.

This midyear rebalance nearly perfectly coincided with the market’s flip-flop in the second half. Many of the new growth sectors plummeted with commodity prices. For example, the S&P 500 Energy Sector Index and Materials Sector Index fell, respectively, 40% and 46% from July through December 2008. Meanwhile, some of the new value sectors—particularly, health care—held up relatively well. If we set aside this unique, near-perfect timing of the Russell style rebalance, we find that 2008 was probably a down year—or at best, a flat, year—for value stocks relative to growth stocks in the United States.

The lack of a sizable value premium in the nasty 2008 equity sell-off is highly unusual since inception of the Russell indices in 1979. In Figure 4, we outline all of the S&P 500 down marketsgreater than 15% in the past 30 years. Value won handily in the markets of the early 1980s and 2000–2002 while also outperforming in the crash of 1987. Value stocks have performed better in past bear markets because they enter the periods with cheaper valuations whereas the growth shares are “priced for perfection.”5 As the economic picture worsens, growth shares have historically suffered more because of the greater revision to future expectations for them. (In the mini sell-off of 1998, growth slightly outperformed value, but that bear market never took hold; it was over before many of us returned from our summer vacations!) In this latest bear market, we find for the first time in a sustained bear market in the past 30 years, that value’s performance versus growth is virtually flat.

We believe the major reason that 2008 bucked the trend toward a clear outperformance by value in a down market is “distress.” Value stocks are cheaper for a reason: They have issues, warts, and problems. Normally, as the economy heads south, these problems don’t prove to be a hindrance to value performance because an expectation of problems is built into the value stocks’ prices. When the outlook turns from recessionary to depressionary, however, the floor under the cheap valuations caves in. Investors’ primary question turns from “how long will it take for the company or industry to turn around?” to “how long will it exist?” More to the point, investors stop asking, “What’s the return on our money?” and start asking, “Will we ever see a return of our money?” With these questions circulating, any security giving off a whiff of distress—in the form of high debt levels, liquidity issues, and so on—begins to sell off regardless of its relative price.6

Table 1 provides an attribution of returns based on deciles of the price-to-book ratio (P/B), which often serves as a proxy for the continuum from value to growth. Consistent with our expectations, the FTSE RAFI US 1000 was considerably underweighted in the most expensive stocks in the large-cap universe (7.9% versus 13.8%). This is a natural outcome from weighting stocks based upon today’s size, not expectations of how large they will be in 5 or 10 years. Just like previous bear markets, these high priced growth stocks got hammered (down 42.7% in the Russell 1000) as a softening economy rapidly altered expectations. The RAFI strategy earned nice excess returns for having less exposure and better stock selection. However, the RAFI strategy promptly gave up this premium and then some on the flip side of the spectrum. The fear of distress caused the cheapest stocks to do even worse than the most expensive. Thus, the RAFI strategy entered 2008 with a larger exposure to the bottom two deciles of P/B. Looking at the 10th decile (stocks priced below 1.1x’s book value as of December 31, 2007), the FTSE RAFI US 1000 strategy had a 6.6% exposure to these stocks versus the Russell’s 4.4% exposure. This small delta was magnified enormously when this batch of stocks finished with declines averaging more than 65%.

The fear of distress, and its effect, is also clearly seen in the role of industry/sector “detractors” in the FTSE RAFI US 1000 relative performance. The U.S. automobile industry was the poster child for distress (it detracted 57 basis points from the FTSE RAFI US 1000 net performance) toward the end of 2008, but this sector represented a rather small holding in both the RAFI and Russell indices. The financial sector held a much larger cumulative position in the FTSE RAFI US 1000 (with a beginning weight of 18.7%) and in the Russell 1000 (17.5%), and it went through a crisis in which many companies’ ongoing viability was cast into doubt. The small overweight in financials in the FTSE RAFI US 1000 was the primary detractor in the RAFI index underperformance in the U.S. large company market. As we stated in August,7 the current upheaval in this sector bodes well for future RAFI performance for two reasons. First, most financial stocks are priced to reflect the most dire of outcomes, meaning that if they simply avoid the worst-case scenarios they could provide outsize performance. Second, every failure of a financial firm reduces competition and gives the survivors more pricing power.

One other factor, which we’ll focus on in an upcoming RAFI Fundamentals, is the interplay between relative performance and relative valuation multiples. Intuition tells us that buying whatever has recently performed best is folly, and that whatever has plunged is (at least) more attractive than it once was. If we assume mean reversion holds, a strategy that allocates greater amounts to yesterday’s laggards but only suffers a fraction of their performance shortfall would seem to be well positioned for price reversals and deliver the goods over a full market cycle.

Many observers may miss the fact that the RAFI strategy performed very nearly well enough outside the United States, particularly in emerging markets, to offset the shortfall in the United States. Indeed, the Fundamental Index concept trailed on a global, all country basis by a scant 60 basis points, after winning handily in 2006 and 2007—all of which occurred after the publication of our methodology and commercial indexes. We believe a 60 basis point global shortfall to capitalization weighting for 2008 is well within the range of expected outcomes in a volatile market like the current one. A prudent fiduciary maintains a long-term view and avoids making snap judgments based on short-term trends. Looking at the RAFI approach’s performance over a long period of time, we are pleased to see that the cumulative outperformance remains.

The collective psyche of investors did a 180 in the past 12 months from a greed-induced spring bubble in commodities to the panic-driven selling of “Everything but Treasuries” in the fall. With the books finally closed on 2008, investors can finally take a breath and evaluate the dramatically altered landscape of the capital markets. This assessment will reveal a host of opportunities. The massive meltdown in virtually all risky asset classes has led many to offer healthy looking forward returns for the first time in years—in some cases, careers. Ignoring the scars caused by the fall, a systematic and model-driven GTAA process scrutinizes this newly golden opportunity set.

The selling of distressed equities has led many companies’ prices to deviate wildly from their economic footprint, exactly the kind of environment that provides attractive prospects for the Fundamental Index approach. Does this environment provide low hanging asset class fruit and an index methodology that capitalizes on the severe mispricings in today’s equity market? Over the long term, investors keen on achieving sustainable investment success would be well served to embrace both. And that’s a rule we can live with.

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1. As a barometer, consider that the average correlation of the S&P 500 with the Barclays Capital U.S. Aggregate Bond Index (the two asset classes most frequently used to offset each other) has been 0.25 since 1976.
2. A correlation of 0.58 is virtually identical to the historical correlation between the MSCI EAFE and S&P 500 since 1970 (0.59).
3. This spread was calculated as the difference between the Merrill Lynch USD Emerging Market Sovereign Plus Index and the U.S. five-year (constant-maturity) T-note. Investment-grade percentages are based on the JPMorgan Emerging Markets Bond Index, courtesy of PIMCO.
4. FTSE does not currently publish a global, all country RAFI Index. Thus, the results presented are a simulation of the RAFI methodology applied to the largest 3,000 stocks by fundamental size in the global equity universe (developed and emerging markets.)
5. Note that in past bear markets, most of the outperformance by the value stocks happened in the second half of the bear market. This fact invites a provocative question: Is the bear market of 2007–2008 over?
6. Indeed, we can venture back to the depressionary 1930s to see value shares underperforming growth in a severe down market. The Frank Russell Company indices don’t extend this far back but Gene Fama and Ken French constructed the Fama–French Large Cap Growth and Value time series to illustrate style performance during this stretch.
7. See the August 2008 issue of RAFI Fundamentals, “The Anti-Bubble Bursts.”