August 10, 2004

Robert Arnott serves as Editor of the Financial Analysts Journal. He has authored over sixty articles for journals such as the Financial Analysts Journal, the Journal of Portfolio Management and the Harvard Business Review. In 2002, he established Research Affiliates to offer products like subadvisory services, software and asset management models. He has joined forces with PIMCO, serving as a subadvisor, to offer the first global asset allocation product to make active use of liquid alternative markets, beyond conventional stocks, bonds and cash. In the past, he also served as a Visiting Professor of Finance at UCLA, on the editorial board of the Journal of Portfolio Management and two other journals, and on the product advisory board of the Chicago Board Options Exchange and two other exchanges. He previously developed quantitative asset management products and teams as Chairman of First Quadrant, LP, as President of TSA Capital Management (now TSA/Analytic) as Vice President at The Boston Company (now PanAgora) and served as global equity strategist at Salomon (now Salomon Smith Barney). He graduated summa cum laude from the University of California in 1977 in economics, applied mathematics and computer science.

Legendâ : Rob, would you describe for us your view of the big picture? What is going on out there?

Robert Arnott: Well, one of the key problems most investors face and many don’t realize they face it, is that the returns of the future are going to be a far cry from the returns of the past. First, basically anything you invest in produces return in the form of income; dividends for stocks and coupon returns for bonds. Secondly, real growth (after inflation) for stocks tends to be about 1%. For bonds of course, the nominal growth is zero, because they are fixed income. You can do that same analysis across a whole panoply of markets but most people have most of their money in stocks – primarily mainstream stocks, and bonds.

The problem is that the forward-looking rates of return for mainstream stocks and bonds are not what people are expecting and not what they are accustomed to earning. If you’ve got bond yields of around 5%, that’s not a particularly impressive return, so a lot of folks turn to stocks; but stocks have a yield of only 1.5% and historically earnings and dividends grow at only about 1% above inflation which leaves you with a situation where the stock market is likely to produce long-term returns of around 2.5% real over and above inflation. That’s only a tad higher than what you’d expect from bonds.

Part of the problem is that as the marketplace has slowly but surely become more aware of this issue. They have responded to that by looking outside of mainstream stocks and bonds as they should but as a consequence they are driving down the yields and hence the forward-looking rates of return on a wide range of markets. There is a lot of talk about a real-estate bubble. All that’s really happened in real estate is that the yields on real estate have fallen roughly in line with the drop in the yields on stocks only with a lag. Most of that drop occurred in the last four years, while most of the drop in the stock yields occurred in the prior four years. We’re looking at a marketplace where a whole spectrum of markets is priced to provide less reward than most people are accustomed to earning and certainly far less than most people are expecting.

The backdrop with market environment is one of reduced future returns but not yet reduced return expectations. Most investors still think they have a reasonable shot at double-digit returns, or at least high single digit returns. And yet when you look at the current pricing and reasonable rates of growth and so forth, you find that a reasonable expectation is 2 to 3% real return over and above inflation or around 5 to 6% nominal return. That’s a lot less than most people are expecting for their money.

Legendâ : When you say the expectations are there, maybe less so now then they have been in the past, is that because predominantly of reduced equity yields or because of higher than normal price/earnings ratios especially when you look at a P/E chart on a 10-year normalized basis?

Robert Arnott: Those are two sides of the same coin. Reduced yield and higher P/E ratios tend to go hand in hand. It’s a bit of both. If stocks are going to pay you 1.5% yield and if you’re only going to enjoy a little over 1% real growth in dividends, that gives you a bit over 2.5% real return. By the same token, if you take earnings and strip away the portion of earnings that are fluff (aggressive earnings management and overstatements), you’re left with a P/E ratio that’s probably in the 30 range. That would suggest a 3% real return. One way to gauge the expected real return is just to take the reciprocal of the P/E ratio, because earnings do tend to grow with inflation. As a result, the earnings yield is a reasonable basis for gauging future real returns. Either way, you’re looking at the same general number – 2.5 to 3.5% as a real return for stocks. Of course the TIPS market tells you what the real return for bonds is – it’s between 2.0% and 2.5% for the long TIPS.

Legendâ : TIPS have been purchased by virtually everyone over the last year or so. The last coupon I heard quoted for TIPS above the inflation adjustment is 1.3%. Is that still true?

Robert Arnott: The 1.3% might be for the 5- or 10-year TIPS. The long TIPS yield right now is about 2.3% or 2.4%.

Legendâ : The 10-year bond was what I had in mind.

Robert Arnott: Yes, the 10-year offers a materially lower yield. If you can lock in 2.3% real over and above inflation indexed to inflation and be guaranteed by the U.S. Government, that’s a pretty good yield. During the 20^th century the average real yield on long government bonds was 1.9%. The biggest risk on long bonds is inflation. If you have an instrument (TIPS) which eliminates that largest risk for long governments, the yield ought to be lower – lower than the 1.9%. My guess is that, in the next ten years, we will see real yields on long TIPS fall below 1.5

Legendâ : What asset classes do you see providing higher returns than the stock and bond markets?

Robert Arnott: Well, right now I think some of the real return assets are interesting. Again, I think TIPS are mildly interesting. The yields are not what they used to be, but they’re still pretty good relative to the long-term historical normal real yield on long government bonds. If yields fall from 2.3% to 1.5% in the next five years, for instance, the total return would exceed 5%, including capital gains. As for REITs – there’s a lot of speculation about the notion of a real-estate bubble. In the home residence market there may be something of a bubble. But if you’re looking at commercial property, it really is driven by yields; those yields have come down in the last four years by only about 2%. That’s in line with what we’ve seen in many segments of the bond market. It’s in line with what we previously saw in the stock market in the second half of the 90s. So, it seems to me that what we’re seeing in REITs is a rationalization downward of the real yield on real estate, commercial real estate and on REITs. I would view REITs as a moderately interesting market. The REIT market tends to offer protection if stocks have a bear market. I would also say that commodities represent an interesting opportunity, because a lot of folks are still not yet believing that inflation is back. But it is. We’ve had over 3% inflation in the last 12 months!

Legendâ : When you’re making statements about REITs and commodities, what kind of nominal return would you think might be possible?

Robert Arnott: With REITs, you’ve got about a 5.5% yield. Historically, rents keep pace with inflation with perhaps a 2% shortfall because properties do depreciate. That means that you’re looking at about a 3.5% real return, over and above inflation, on REITs. That compares very favorably with both stocks and bonds and it also compares favorably with TIPS. If you earn a 3.5% real return, that would correspond to most likely 6% or 7% as a nominal return. Similarly, if you look at emerging markets debt, the emerging markets debt is priced based on expectations of future defaults and so carries about a 3% premium yield over Treasuries. Historically, the default rate has been closer to 1% and the quality of this debt is a lot higher than it used to be. In fact, half of the emerging markets debt market is now investment-grade where 15 years ago none of it was investment grade. With emerging markets debt, again, you are looking at a potential for roughly a 6% to 7% nominal return.

One of the things that I find interesting in today’s environment is how everything seems to be clustering together in the same general range. The more interesting markets are all priced to give you 5, 6, 7% returns, not 10 or 12 or 15% which is what a lot of folks seem to expect. To my way of thinking, the correct investment strategy in that environment is to diversify broadly because any of these markets can correct, creating a buying opportunity. Therefore, you don’t want to be overexposed to any of them. It will be best to concentrate in the markets that are priced to provide the moderately higher returns, at this time. There are no markets that are priced to provide drastically higher returns. The last time we saw that was about 18 months ago when TIPS and emerging markets debt were both very, very attractive.

Legendâ : What about domestic high-yield bonds? They’ve had a good run. Is that pretty much over with?

Robert Arnott: I think emerging markets debt is more interesting. The default risk is lower. The notional yield is comparable. The plunge in the dollar helps emerging markets bonds, because they export worldwide, but owe their debt in newly-depreciated dollars. Also, if we do slide into a recession at some point in the next year or two, the high-yield sector will be hurt more than emerging markets bonds. I think the run we’ve seen has been marvelous but that’s behind us.

Legendâ : One of the assets Bill Gross keeps referring to especially of late is the attractiveness of foreign bonds. Do you view that similarly? I presume he’s talking about investment-grade in that case.

Robert Arnott: I think they are more attractive but I don’t think they’re drastically so. I think the better opportunities are found outside of mainstream bonds.

Legendâ : What is your view of the hedge fund world?

Robert Arnott: The hedge fund world is an interesting business. There is a flood of money going into hedge funds, based on a supposition that they can continue to deliver the 10% to 20% returns of the 90s. They are also ostensibly more market neutral and less susceptible to over and undervaluation of stocks or bonds. I believe that’s naïve. I think a lot of the buying of hedge funds is based on flawed logic – the logic that the past portends the future. I think there are a lot of good hedge funds out there, but I also think there are a lot of bad hedge funds out there. It makes sense to recognize that the hedge fund community isn’t really an asset class. It’s an array of strategies that span multiple markets. One implication of this is that there will always be good and bad hedge funds. Investors who go into a hedge fund community very carefully, knowing what they’re doing, are probably going to be fine. They’ll probably find the hedge fund managers who produce attractive rates of return.

Most of the people going into the hedge fund world are simply chasing yesterday’s returns. They keep piling money into the funds that have done well historically and that are household names in effect, that are well-respected in the marketplace, and because of that they’re paying top dollar for what is likely to be relatively average performance. Now, what do I mean by average? If stocks and bonds are priced to give you 5 to 6%, I think the average hedge fund is not likely to do materially better than that. If the average hedge fund produces, let’s say, 7 or 8% gross, then, net of fees, you’re down to 5%, and net of taxes you’re down to 3%. You can do better than that in plain old municipal bonds. So I think most investors piling into the hedge fund world are probably making a mistake. This is very much in line with what Bill Gross said in his August Investment Outlook.

Legendâ : There are two follow-up questions to that statement. If there is too much money spent chasing too few opportunities and, is it that those strategies can’t take more money on? Gross seems to be implying that the only way hedge funds are going to make anywhere near the kind of returns they did in the past is by employing a significant amount of leverage as opposed to taking advantage of natural opportunities.

Robert Arnott: Yes, I think there’s too much money chasing too few opportunities. I’d agree that many are using leverage to make up for the low returns available in the markets. Another LTCM-scale blow-up is almost inevitable in the next couple of years.

Legendâ : The other question is, based on some research you’ve done in the past and in view of your market outlook, what of the primary hedge fund strategies that are out there do you think look more or less promising if one would want to devote some money to hedge fund type strategies?

Robert Arnott: Let me zero in on four broad categories. First, there is the convertible arbitrage market. Convertible arb has attracted a flood of money. I understand that roughly 85% of the market capitalization of convertibles is now held by convertible arbs. I don’t see how they can add value if they own 85% of the market. I think that’s an accident waiting to happen.

At the other end of the spectrum, global macro is a bet on manager skill. If you have a manger who has a clear world view, who has a strong awareness of risk and manages the risks appropriately, I think there will be global macro managers who do very, very well for their clients.

I think market-neutral equity also represents an interesting opportunity. There are a fair number of players but the aggregate assets of the market-neutral equity world is still not terribly large. I think the opportunities there are going to be less exciting than with global macro but the flip side of that is if you wind up disappointed with market-neutral hedge funds, they won’t be as disappointing as the worst of the global macro managers. Global macro is a leveraged bet on manager skill.

The fourth area that I think is interesting to consider is the merger arb area. Merger arb works when there are mergers. Mergers slow down in a bear market. I don’t think we’re that far away from the next bear market. I think next year is likely to be a bear market year. I think merger arb is less likely to be an interesting market. I also think we’re in a secular bear market that will span multiple market cycles. As a result I believe merger arb will be less exciting than it used to be.

I would agree with Bill Gross that the amount of money flowing into hedge funds doesn’t mean that in order to earn the returns of the past they need to leverage, and as a result they will leverage. Instead, in order to seek those returns they will be tempted to leverage. Many funds will therefore inappropriately leverage beyond what is comfortable and secure.

Let’s take the Long Term Capital Management (LTCM) example. LTCM’s demise was a major implosion of a hedge fund that could have put some large broker-dealers and banks out of business. The Fed arranged a safety net, so that the investors (the big broker-dealers and banks) in LTCM would not go bust. Bluntly, I think that was the biggest mistake Greenspan ever made. If he had not bailed out LTCM, there would have been a few large banks and/or large broker-dealers that would have gone under, which would have served as a warning that the notion of too large to fail is a flawed notion. I think that this bailout set the stage for the bubble. I think it set the stage for a rather mindless boom of money flowing into hedge funds; for most investors, these investments are not well thought-through.

Given the fact that the LTCM collapse occurred when there were a third as many hedge funds with a fourth as much in assets as there is today, I think we’re going to see an LTCM-scale blowup again in the next year or two. There is a concept in finance known as "moral hazard" which basically means that if I win, I win, and if I lose, you share the burden. That’s what happened in LTCM. If the government permits moral hazard, and encourages society at large to share in our downside risk, there is an unhealthy willingness to take risk. That risk can be excessive and right now probably is.

Legendâ : Rob, can you elaborate a little bit on long-short?

Robert Arnott: Sure. Long-short is one of the more popular categories. It’s a stock-picking game. It’s a game focused on identifying stocks you think that will go up handily and stocks you think will do badly. But its not tightly risk-managed the way market-neutral investing is managed. It has a long bias. One of the reasons long-short has done better in the 90s than market-neutral is the long bias of the strategies. If you’re long $100 million in stocks and short $30 million in stocks, your net position is $70 million invested. With market neutral, you truly are neutral; you may have $100 million long and $100 million short, so you truly do have a neutral posture relative to any market movements. This means that long-short managers who look pretty good now because we’ve had a bull market over the last 22 months, probably are going to do a good deal worse than market-neutral in the coming couple of years, especially if we see the bear market that I think is likely.

Legendâ : You mentioned earlier in your comments that we’re in a secular bear market. We would certainly tend to agree. Probably you could point to basically March of 2000 as the start date. As we observe long-term bear or bull markets (secular moves) especially based upon rising and falling 10-year normalized P/E ratios, it appears that those secular bulls and bears run anywhere from 17 to 20 years. Is that your view as well?

Robert Arnott: Exactly right. The average secular bear market spans not quite 20 years and spans 3 to 5 cyclical market cycles. After the secular bull market ended in 1965, it took until 1982 for those excesses to wash out of the market. The one that ended in 1929 took until 1949 for the market to definitively regain a positive momentum. From 1901, you had to wait until 1921. Those are long spans. They span multiple market cycles. It takes time for the psychology and the excesses of a secular bull market or a large bubble to get washed out of the market. Now, after the largest bubble in US capital markets history, I think it would be naïve and dangerous to expect a milder outcome than the ones that we’ve seen historically.

Legendâ : Japan has been in a secular bear market for the past 15 years. It seems like there is some rationalization to allocate capital to Japan for the first time in a long time. In the U.S., we’re just entering the secular market. Are they getting ready to come out of one?

Robert Arnott: Well, theirs started 10 years earlier than ours. I It’s a sobering warning that the Nikkei 225 came very close to 40,000 at the end of 1989 and today it’s still languishing 70% below its 1989 highs, and was as low as 8,500 at its market lows 18-24 months ago. I think it’s very worrisome that so many people think that the U.S. market is immune to that. Japan is the second largest economy in the worldand was briefly the largest stock market in the world. To think that we are immune to a secular bear market of similar magnitude is naïve and dangerous.

That said, I would say the opportunities in Japan are a lot better than they are here, and the reason I would say that is quite simply that in Japan, the political and economic pressures are such that the government would be highly unlikely to take steps that would be seriously damaging from current levels; indeed, their government might actually get it right. We’re early enough in our secular bear market that there are still plenty of ways that our government can screw things up.

Legendâ : Looking at the large cap universe which now has been down or flat for five years, are there any traits and characteristics that you like within that universe? Are there any areas where you think there are bargains or likely to be bargains in the next 4 or 5 years or anything that you want to avoid?

Robert Arnott: I see less bargains than I see excesses. I think what we’ve seen an echo of the bubble in this current bull market. The stocks that did very well in 1999 and early 2000 are, in many cases, the very same stocks that did very well in 2003 and early 2004. It’s extremely unusual that the leadership of one bull market is the same as the leadership that we had in the prior bull market. I cannot recall a prior bull market that had that characteristic. I think the same excesses we saw in the bubble have returned on a much smaller scale this time around, but they’re still excesses.

One thing that I think is very interesting is the battle over expensing of management stock options. I think stock options are a wonderful thing. They align management’s interest with shareholders. They provide an incentive for attracting top management talent without having to lay out compensation packages that are assuredly huge. But I think it’s not moral and not correct to pretend that stock options are free. Stock options are an expense. They are a form of compensation. They do reward management for enriching the shareholders with rising stock prices. They do reward management for doing the things that get noticed in the stock market and rewarded with higher prices.

If you look at the distribution of stock options, in the tech arena, earnings are very close to zero net of stock options. If stock options were expensed, the average earnings base on the NASDAQ would be down about 70%. Outside of the NASDAQ, the impact would be less than 10%. So that tells me that the reason that they’re fighting ferociously is that the emperor has no clothes and that the expensing of stock options will reveal that the emperor has no clothes. I see an interesting opportunity for a shift towards value and towards mid-cap. These are opportunities that I think will be rewarded. Even if we have a bear market, those stocks won’t necessarily go up, but they won’t go down the same way that the current mini-bubble stocks will.

Legendâ : Rob, what do you think of the 1940 Act fund-of-funds that are proliferating? What kind of return would be reasonable to expect from these vehicles and what problems do you see with them? Obviously there’s another fee layer. Where are we heading?

Robert Arnott: I think 1940 Act fund-of-funds could be compared with hedge fund fund-of-funds. With 40 Act fund of funds you have both the underlying fund fee and the fund of funds fee. With hedge fund fund of funds, you have the same thing. The difference is the scale of the fees. Take the PIMCO All Asset Fund as an example. The asset allocation fee is only 25 basis points. With a fund-of-funds in the hedge fund world, frequently you are looking at 1% plus 10% of the return which means that if they earn 10% gross, they’re going to take a 2% fee. That is on top of the underlying funds, which typically charge a 2% annual fee plus 20% of the return. So I think the opportunity to add value with a 40 Act fund-of-funds is terrific. I think the fee structures are so much more sensible that there is a lot better chance that the benefit will flow through to the shareholder instead of just the manager. I think if you wind up with a high single digit return from any of these funds, that’s a win, but it’s far more likely in the 40-Act funds-of-funds.

Legendâ : Can you give us your views on where you think interest rates might be moving?

Robert Arnott: That’s actually a tougher question than it sounds. It’s a two-edged sword because I think inflation is on its way back. I think the fears of inflation which are surfacing just around the fringes of the policy-making community are understated. I also think the concerns about a risk of deflation to the extent people still harbor those fears are way overstated.

Here’s the problem. Real interest rates are pretty good. The slope of the yield curve is moderately steep. Real interest rates on short-term bonds, notes and money markets are all negative. They’re all trading well below the Consumer Price Index (CPI). Two of the best predictors for inflation are current real interest rates and the slope of the yield curve. The higher the real interest rates are, the lower future inflation will be. Right now they’re negative. That’s bad. The slope of the yield curve is the second best predictor for inflation. It’s very steep. That’s bad. The likelihood is that over the coming three to five years we’re going to see a resumption of inflation. Hopefully, it’s not as bad as the stagflation of the 1970s.

Now, what does resumed inflation do for interest rates? Normally, rising inflation is terrible for bonds. Today, with bonds trading at 2.5% real yields, that’s not as clear. Inflation could ramp up to 4% and long bonds with a 5% yield could actually still hang in there. Actually, a 5% long bond yield would be a small rally from current levels. Conversely, you could see inflation go to 5 or 6% or higher in which case there is no way the long bond would stay at current levels. It would have to go up in yield, down in price. As a result, it’s tough to call the long bond market right now. If I’m wrong about the reflationary thesis, then it’s a fair bet that bonds will do extremely well.

Legendâ : What do you think about alternative fixed income investments such as bank loan and stable value funds?

Robert Arnott: It’s all in a quest for the elusive higher returns that are tougher and tougher to find. The bank loans market is an interesting market if we don’t reenter recession. If we do there’s going to be a lot of defaults. Many of the risky markets that investors go to for higher yield offer a skinnier yield premium than they used to offer. High-yield bonds don’t offer anywhere near the yield premium they did two years ago. I think a lot of folks are going to get burned in the next recession. The safest investments in a recession are assets with very low volatility and with a value bias but not assets that have a particular large default risk.

Legendâ : You just mentioned the possibility of reentering a recession. What is the probability of that occurring and what would you view as being the key indicators that that would be happening?

Robert Arnott: Recessions are awfully tough to call, except in retrospect. They’re very easy to identify with 20/20 hindsight after a 6 to 12 month lag. I think that when you see an overheated market, you are at risk of creating the environment in which a recession can kick in. I think whoever is elected President (and I think it’s economically irrelevant whether Bush or Kerry is elected), they’re going to face a bear market fairly early in their tenure. They’re also going to face a recession at some point early to mid-point in their tenure.

The current stock market conditions I think are not encouraging in that regard. I think the reflationary economy is problematic. The biggest worry that I would have is a return to the 1970s style stagflation, where the economy goes sideways and the Fed has used all of its ammunition in the form of negative real short-term interest rates, and has nothing left to help in the fight against recession. Right now they really do have nothing left. They’re offering money at 1.5% negative real rates.

Legendâ : Thanks, Rob!

For further information about evaluating the quality of a company’s earnings, call LOUIS P. STANASOLOVICH at (412) 635-9210.