How to Play a 'Take-No-Prisoners' Market Rob Arnott, Founder and Chairman, Research Affiliates

INTERVIEW

AN INTERVIEW WITH ROB ARNOTT: Given the abundance of low-hanging fruit, it's a mistake to stick with things that will soon go out of style, such as Treasuries. Promising areas: emerging-markets and convertible debt.

ROB ARNOTT, FOUNDER AND CHAIRMAN OF ASSET MANAGER Research Affiliates in Newport Beach, Calif., is one of the big thinkers in finance today.

A former editor of the prestigious Financial Analysts Journal, Arnott, 54, has developed expertise in asset allocation, indexing, and pension funds, among other topics. He's a fierce proponent of fundamental indexing -- in which metrics such as aggregate sales and cash flow are used to weight companies in an index, as opposed to market capitalization.

With the markets in tatters, Barron's turned last week to Arnott, who in a wide-ranging conversation had plenty to say about fundamental indexing and many other subjects. "This is not a time to shy away from taking risks," says Arnott, who maintains that the market's upheaval has created great investment opportunities, including value stocks and convertible bonds. "The markets are priced right now to reward risk-bearing more than any time in many, many years," he says. Hence, he sees Treasuries, which had a relatively strong '08, as the worst place to put money next year.

Ian White for Barron's

"A year from now, investors in convertible bonds are likely to be very pleased with what they see in terms of prices and yields." – Rob Arnott

While the fundamental index Arnott uses smartly outran the Standard & Poor's 500 from 2000 to 2006, it underperformed the S&P in '07 by three percentage points and is behind in '08, as value stocks got shellacked. Yet Arnott's faith in the approach remains unshaken. To find out why, please read on:

Barron's: What are your thoughts on this year's dismal market?

What we've seen is the consequence of reckless indebtedness. Subprime was the tip of the iceberg. I found it interesting that folks in government were dismissive of subprime as being not a terribly important issue as recently as late 2007 and even early this year. There's been this pattern of aggregate indebtedness at the corporate level, at the household level and at the government level. It's dismissive of the need to pay things back. As a result, when things started to go sour on some of this debt, beginning with subprime, the cascading effect was beyond what most people could have anticipated. I was a bear coming into this credit crunch, and I actually was labeled a perma-bear. And yet this contagion effect went a lot further than I would have predicted, and there are very few observers who expected anything this severe. But the seeds of it were sown quite aggressively over the last decade.

How did all of that fall into place?

The indebtedness of the United States rose from five times [gross domestic product] to eight times GDP in 10 years. That is reckless, but that's what has been going on. That sowed the seeds for what we have seen. The deleveraging that has taken place has cascading effects that can come from a lot of different directions and can afflict a lot of different markets.

What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally in November, we saw the beginnings of a rationalization where some markets did begin to recover -- but some markets had been hit beyond any rational valuation of the risks associated with those assets.

What should investors be doing differently in the wake of this huge market downturn?

As shown by the collapse of Bernard Madoff's firm, investors should act with due diligence -- that is, they should be more alert to the risks. We have had a cult of equities develop over the last 20 years in which equities were seen more as the low-risk asset, even the risk-fee asset for those who had a long-term orientation, and that is foolishness. If you are bearing risk, you should get paid for it. If you are picking up nickels in front of a steamroller, trying to identify opportunities to add one-tenth of a percent to your return by taking risks that could cost a 100 times that, that doesn't make sense. People need to be more disciplined about that. That includes individuals, corporations, and banks.

In light of what's happened this year, what's the best way to approach asset allocation?

Almost everybody, retail investors and institutional investors alike, invests with their eyes in the rearview mirror, favoring what has worked best in the past. But there is a very powerful pattern of mean-reversion in the markets. What has done spectacularly well often takes a rest or it takes a bear market to get back to normal. So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors. That goes for your readers, and it goes nearly as much for highly sophisticated institutional investors. This temptation to buy what has done well is the single greatest pitfall in investing, and it is the single reason that a disciplined approach to asset allocation can actually work very, very well.

What's an example of a promising area hit hard?

The average convertible-arbitrage hedge fund was down about 50% year-to-date at the end of last week. But that result for a long-short absolute-return, fully hedged strategy makes no sense. The temptation is to get out, which is what a lot of investors are doing. The other way to look at it is that the forced liquidations of these hedge-fund positions create new opportunities, namely convertible debt priced at extraordinarily attractive yields. The same thing holds true for emerging market stocks and bonds, along with TIPS [Treasury inflation-protected securities].

A year ago, folks were probably getting tired of hearing me say there is no low-hanging fruit and that there are no attractively priced markets, both relative to other markets and relative to their own history. I also was saying not to expect double-digit returns and to take risk off the table.

What's your view now?

It's pretty much the opposite; this is the richest environment of low-hanging fruit I've seen in my career. And you would have to go back to 1973, 1974 or even, in some markets, to the Great Depression to find markets priced as attractively as now. This is not a time to be hunkering down in the safety and comfort of the Treasury curve. There are tremendous opportunities right now. It is so tempting in a bear market to focus on the glass being half-empty and on how much has been lost. But the glass being half full side is largely ignored.

What kind of an asset-allocation mix makes sense to you?

First of all, most investors think that putting some money in growth stocks, some money in value stocks and some money in international stocks is a well-diversified portfolio. It's not. Diversification means taking on risk in markets that are uncorrelated and that can go up when other markets go down. So a well-diversified portfolio should look at multiple sources of risk, not just in stocks.

Where do you see opportunities?

A year from now, investors in convertible bonds are likely to be very pleased with what they [see] in terms of prices and yields. The same holds for emerging-market debt denominated in the local currency, which I prefer to dollar-denominated debt. You get a premium yield for emerging-market debt and an additional premium for investing in the local currency. Tacitly, that's a dollar bet, but I don't see how the dollar can do well on a long-term basis when we have indebtedness that is eight times our national income. Imagine an individual going to a bank and saying, "I owe eight times my income and I would like to borrow more." The reaction would be immediate and drastic: "Give us your credit cards; we will slice them up." But as a nation we still have our credit cards, and we are still using them aggressively.

What other kinds of investments look good to you in terms of asset allocation?

I also like TIPS. How can we get out of this current mess without renewed inflation? A lot of folks are deeply concerned about the risk of deflation. The temptation is to look at history, especially the Great Depression, which was a deflationary depression and which started with very, very low national indebtedness. If you have very little debt and you have a depression, it is likely to be deflationary. If you have very high debt and you have a depression, it is likely to be massively inflationary. The contrast with Germany in the 1920s is noteworthy; they had massive indebtedness and hyperinflation. I'm not suggesting a risk of hyperinflation. But I am suggesting that people are too glib about tossing aside the risk of inflation, which was front and center less than six months ago for most investors.

What's your sense of opportunities in value stocks versus growth stocks?

When you look at price-to-book values, the spread between growth stocks and value stocks was at its narrowest ever, just two years ago; now, it's the widest spread ever with the sole exception of the bubble year, in 2000, and we saw what happened after that: seven years in which value drastically and reliably outperformed growth. We could see something similar [now], whereby value sharply outperforms growth. The value side of the market, like much of the bond market, is priced for a depression. The growth side of the market is priced for recession.

You are a big believer in fundamental indexing, in which metrics such as dividends and book values are used to determine a stock's weighting. That's in contrast to weighting an index by market capitalization, such as the S&P 500. The FTSE RAFI 1000 Index, which takes a fundamental approach, trailed the S&P 500 this year by about three percentage points, as of Dec. 16 -- although it has outperformed over longer time horizons. What caused that underperformance this year?

It's due entirely to value [stocks] getting shellacked. The capitalization-weighted indexes put more money into companies if they are trading at high-valuation multiples. So, cap-weighting systematically puts most of your money in growth companies, while a fundamental index has a value tilt relative to the market. Value was savaged in '07 and '08. So the fundamental index underperformed surprisingly modestly.

In contrast, the FTSE RAFI All World 3000 was down 39.46% year-to-date as of Dec. 16, more than 200 basis points ahead of the MSCI All Country World Index. And it outperformed last year as well. So [fundamental indexing] has won worldwide in extremely difficult markets. It has not won in the U.S. in '07 and '08, but the shortfalls are pretty mild -- considering how severe things have been on the value side of the market.

You've said that investors can't bank on equities returning 10% every year, on average. What's a realistic target?

The yield for U.S. stocks is around 3.5%. Historically, earnings and dividends have grown about 4.5% per annum. So if you have 4.5% growth and a 3.5% yield, that's an 8% return. I'm sure your readers would love to hear a forecast of double-digit returns, especially given the biggest bear market since the 1930s. However, our starting point was from valuation levels that were so very rich that we are now merely back to levels that could provide long-term returns of around 8% from current levels. There are segments of the bond market where we can almost assuredly do better.

You don't sound like you are sold on stocks, Rob, even after this huge selloff.

The problem I have with stocks -- and it is a very simple problem -- is that while stocks are nicely priced, they aren't attractively priced relative to their own bonds. The savagery of September, October and November was more drastic for bonds than it was for stocks. A 40% drop in stocks is big. A 20% to 30% drop in major categories of bonds is immense. So the take-no-prisoners market actually widened the opportunities on the bond side even more than on the stock side.

Investment-grade corporate bonds are a vivid example of that. The yield spreads over stocks is averaging about six [percentage points] right now. If you can get a 3.5% yield on stocks and 9.5% on the same company's bonds, which is going to give you the higher return? The stocks will, if they show earnings and dividend growth faster than 6% -- but historically that's a stretch. So the bonds have been savaged worse than the stocks have, and actually represent the most interesting opportunity.

So you are talking about investment-grade bonds?

Yes, investment-grade bonds. But for bonds below investment grade, the spreads are quite extraordinary. By the end of November, spreads had widened out to nearly 20 percentage points above Treasuries and also above the corresponding stock yields. Suppose 40% of those bonds go bust next year. And suppose that you get 50 cents on the dollar back on the bonds that go bust. By that point, you have lost your spread of 20 percentage points.

But such a scenario has to happen every year, until the high-yield bonds mature, in order to merely match Treasury returns. A 40% default rate every year for several years would be truly without precedent. So I view 2009 as an "ABT" year -- Anything but Treasuries. The less you hold in Treasuries, the better you are likely to do.

Has the market bottomed out?

There is a slightly better than 50-50 chance that we see another leg down in the stock market. That's because the deleveraging in the economy is only partly under way, and there is a lot more of it to come. The mass liquidation of hedge funds is not done. As for the economy, I'm expecting 2009 to be a bit worse than people expect. I see the housing market turning in late 2010 or early 2011, definitely not next year. It would surprise me quite a bit, however, if the risky categories of bonds take another significant leg down.

It's been a tough time for indexing, given that so many index returns are negative this year. What kind of an impact will this down-market have on indexing?

People put money into index funds partly because indexes beat most active managers. Nothing is going to change that because, collectively, active managers hold essentially the same assets as the indexes. So collectively, their returns have to be the same, minus costs, which are larger. As a result, indexes will continue to win on a long-term basis. When they underperform, they tend to underperform by less than they win when they outperform. All of this means that demand for indexing is not going away, and it will continue to be a major source of growth among institutional and retail investors. We will see more index offerings so that people can choose different kinds of indexing, such as fundamental weighting.

What's ahead for hedge funds?

There are a lot of good hedge funds out there. But the situation regarding Bernard Madoff's firm illustrates that hedge funds have very little transparency and that their customers don't demand transparency.

I think the aftermath of this will be that some form of regulation in the hedge-fund world is coming. The more the industry embraces and tries to steer that dialogue, the less displeased they will be with the outcome. Still, a lot of investors have had multiple wake-up calls this year about the need to ask more questions and the need for basic due diligence. Too much of the hedge-fund community, however, is still a wealth-transfer vehicle from client to manager. We will continue to see substantial liquidations, which will continue to exacerbate the deleveraging problems we have right now.

Could you elaborate on your point about hedge funds being a wealth-transfer vehicle?

If a hedge fund charges a 2% management fee plus 20% of the gains, that is the classic fee structure. If a hedge fund is extraordinarily good, it is worth the cost. But the fees don't make the manager good; it is the other way around -- it's the skill of the manager that justifies the fees. A lot folks go into these funds thinking, "Well, if these guys can charge 2% plus 20%, it must be good." And some of these funds are good. There are 10,000 hedge funds out there, and maybe 500 of them are good. But 400 of those funds are closed. So finding the 100 that are open and good in a universe of 10,000 managers is highly implausible.

Thanks, Rob.