If we believe in higher long-term inflation over the next decade,3 then equity valuations are likely to contract, meaning our Building Blocks return forecast for stocks and bonds may be too high. Stocks will produce less due to the downward pressure on valuation multiples, while higher inflation eats into today’s skinny nominal bond yields. So, one lesson of the Lost Decade is likely to hold true—an equity-centric mix of mainstream stocks and bonds is likely to disappoint. Again. Net of inflation, it could even be worse than the past 10 years.
Diversification and Alternative Assets—With No Fat Pitch, Think Tactical
A key tonic to the past 10 years was a more diversified, less equity-centric approach. A risk premium government bond isn’t restricted to equities; plenty of assets offer premiums in line with stocks and occasionally higher. In the last issue we used the 16-asset class portfolio4 to illustrate the benefits of diversifying across a wider spectrum of asset classes. For the decade 2000–2009, this more-diversified approach achieved an annualized return of 6.8%, a 450 bps premium over 60/40. Abandon cap weight for stocks and the return jumps to 8.5%, nearly matching most investors’ targeted returns.
Looking forward, the outlook is not as “attractive” as it was in 2000. Today, yields on most of these diversifying assets are well off the rich premium levels at the turn of the century. Back then, NASDAQ-induced neglect led to a whole spectrum of alternative asset classes, favorably priced for attractive long-term returns. Today, we aren’t so lucky as many off-the-beaten path categories sport rock bottom yields (and, therefore, low forward-looking returns). Figure 2 provides a quick snapshot of “Then Versus Now” in four asset classes: REITs, TIPS, emerging market bonds, and high-yield bonds.
Emerging markets bonds, REITs, and TIPS offer half of their Y2K yields. Even high-yield bonds, whose 1999 yields were pushed down due to heavy issuance by adored tech and telecom players, show significantly lower yields today. The fat pitch of diversification into risk premiums beyond mainstream stocks and bonds is largely gone.
So what to do? Manage the asset mix! Vitally important in this exercise is to shift risk postures. Too often asset allocation programs are governed by a relatively constant risk tolerance, say on par with a 60/40 stock/bond mix. This approach encourages swapping one risky asset class out for another (e.g., non-U.S. developed stocks for emerging markets stocks, REITs for U.S. stocks, etc.). But in the current environment, when all asset classes are rich, shouldn’t we consider a more conservative posture? This approach isn’t market timing but risk budgeting. We choose to take long-term risk when risk-bearing is likely to be rewarded, and a conservative, well-diversified posture when it is not. Rich forward-looking risk premiums typically prevail when investors are terrified, as they were in early 2009. As Warren Buffett suggests, we should be “greedy when others are fearful and fearful when others are greedy.”
Out-of-mainstream markets can still add value if we use them tactically and opportunistically. Inevitably, investors sell the assets they least understand when times get rocky and buy them when conditions are calm. Thus, diversification can still be powerful, but only if we practice diligent tactical asset allocation.
Outlook for Equities? Depends on your Index!
Stocks were terribly disappointing during the Naughties, but the results of the Fundamental Index approach (and, for that matter, equal weighting) illustrate that the shortfall was largely attributable to the cap-weighted construction of traditional indexes. Never rebalancing and always chasing winners, cap-weighted indexes held far too much in new age tech before the 2000–2002 bear market and far too little in the left-for-dead financials, industrials, and consumer sectors ahead of the Mother of All Recoveries that closed out the decade.
But the destruction of capitalization weighting wasn’t restricted to these two bookend years as evidenced in Table 3. A global, all country Fundamental Index (FTSE RAFI® All World 3000) portfolio beat the representative global, all country cap-weighted portfolio (MSCI ACWI) 9 years out of 10, falling short by a scant 30 bps in 2008. Even equal weighting, the most naïve of all price-indifferent approaches, managed to win by 600 bps and did so consistently (8 years out of 10).
Of course, yesterday’s winners typically become tomorrow’s laggards. However, a comparison of current valuation discounts for Fundamental Index strategies versus cap-weighted ones indicates that avoiding the negative alpha of capitalization weighting is likely to still be profitable at today’s valuation levels. Previously, we noted that when RAFI US Large trades at a price/book ratio 27% or more “cheaper” to the S&P 500, the odds are good for subsequent outperformance—in the United States, the RAFI portfolio beats the S&P 500 in over 80% of subsequent three-year periods, with an average of 3.6% of additional return.5
So where does this discount stand today? Despite achieving its second best year ever of relative outperformance in 2009, the FTSE RAFI US 1000 still trades at a discount of 48% to the S&P 500. Similar discounts can be had elsewhere, including 38% for a Global All Country application as evidenced in Table 4. These approach the historical peak discounts seen at the top of the Tech bubble in early 2000.
It’s not realistic to expect another 10 years of 600–700 bps per annum return drag from capitalization weighting. Nonetheless, given today’s discount levels, we expect continued sizeable gains from non-cap-weighted indexes and, therefore, continued benefits from using a Fundamental Index approach.
“Lost and Found” will not describe investment results for the first two decades of this millennium, as sizeable real returns will prove to be difficult for the second 10-year stretch in a row. Most investors will fall short of their goals, as almost all asset classes—whether mainstream or alternatives—are priced richly relative to historical norms. But odds can be tilted back in our favor by tactically altering our portfolio risk based on measures as simple as yields and yield spreads. The most successful investors are those with the discipline to shun risk when the markets seem tranquil, and the fortitude to seek risk when others are terrified. The best path to future success marries risk management—tactical asset allocation—with a more efficient beta like the Fundamental Index methodology and a full toolkit of alternative markets.