Everybody loves a good story. But when people invest based on those stories, they can lose money, says Rob Arnott.
The 60-year-old founder and chairman of Research Affiliates prefers to stick to the data. The numbers have led Arnott to some unconventional investment strategies. The most famous of Arnott's inventions are “smart beta” funds, which use non-traditional indexes to invest based on fundamental measures -- such as sales, dividends or cash flow -- rather than market capitalization.
About $177 billion are now managed in funds and strategies developed by Research Affiliates. Founded in 2002, Arnott's firm is the adviser for more than $61 billion at Pacific Investment Management Co., half of that in the Pimco All Asset Fund (PAAIX). Over the last 10 years, it's up an average of 5.5% annually. However, with about 8 percent of the fund in emerging markets currencies, it's down 4.25% this month.
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Arnott is making long-term bets on emerging markets because his calculations make him gloomy about U.S. stocks and the long-run growth of the U.S. economy. As he told Bloomberg.com, the rest of the world is full of opportunity for the patient and brave investor.
What's the biggest source of risk for investors today?
Markets are expensive. The most popular markets, particularly U.S. growth stocks, are priced to an expectation that things will sort out very, very well. It leaves very little room for disappointment.
What assets or investments are overhyped?
U.S. equities are among the more expensive markets in the world. I wouldn't describe it as a bubble but I'd describe it as very expensive. U.S. stocks are priced at a Shiller P/E ratio - price relative to 10-year earnings - of 27 times. It's been higher twice in history, during the tech bubble and in 1929.
So anyone buying U.S. equities is making one of two assumptions. [First, that] U.S. equities are still, today, priced to offer solid long-term returns relative to the whole spectrum of alternatives available. I don't believe that.
Or, they believe they'll hear the bell chime when the merry-go-round stops. And they'll hear it before others do. That's a pretty heroic assumption.
Or, [they can] recognize that maybe this is a game that they prefer not to play. I fall squarely in the latter camp.
So what games do you play instead?
There's a [wide range] of markets available to us and some are pretty cheap. Emerging market stocks are priced at 15 times their 10-year earnings. If you use a fundamental index, they're priced at 11 times their 10-year earnings. Eleven times. That's cheap.
I'd much rather put my money there and wait patiently than try to play the game of guessing how much further this bull market can run. Folks who harbor the illusion that they can pick the top are deluding themselves.
Russia is cheap, assuming your assets aren't expropriated -- that's not in the model. If I don't mind supporting a thug-ocracy, then that's an interesting investment. But I sure don't want a large part of my money there.
You've written that a big difference between developed markets and emerging markets is their demographics. Why does that matter so much?
The heart and soul of macroeconomic growth is young adults. Productivity rises fast among those who are young and have rapidly growing skills. When you're at peak productivity [in your 40s, 50s and early 60s], your contribution to GDP is fabulous. Your contribution to GDP growth is zilch.
So economies that have a slow-growing, mature labor force are going to be prosperous but slow-growing. Meanwhile, emerging economies of the world are right at the sweet spot for GDP growth. The median age in the emerging markets is 30. In the developed world, [it's] 43.
Would I rather [live] in a slow-growing economy with maximum prosperity, or a fast-growing economy with less prosperity? Clearly I'd prefer the former. But most people want it both ways: They want prosperity and they want fast growth. OK, well, dream on.
So developed economies like the U.S. are doomed to slow growth?
If the median age is 43, you're past the fast-growth phase. We were in it from roughly 1950 to the early 2000s. What we think of as normal growth - 2% to 3% per annum - is abnormal growth with a demographic tailwind. In 10, 20 years from now, 1% real growth will be a win. And that's OK. It's still growth.
It suggests that the investing opportunities in developed markets are going to be lower than in emerging markets for quite a while.
Right. It also means that the natural real yield on bonds [is going to be lower]. We've seen real yields tumble to within rounding range of zero. People think this is very strange and yields should go soaring back up again. No. To borrow from Pimco's old expression, this is a “new normal.” The new normal for growth is slow growth. And if the growth is slow, real interest rates are going to be low. If real growth is negligible, zero real interest rates -- if there's no risk of default -- makes perfect sense.
It sounds like it won't be getting any easier to make money in the markets. How do you see the investing business changing in the next 10 years?
I'd like to see the end customers take more interest in investing, and become to some extent students of the markets. When people invest, they often do it very casually without a great deal of thought. They often do it in an instinctive, trend-following way.
In choosing their own investments, people will often go through a list of funds. They say: “Hmm, this one's done really well in the last one, three and five years. I like that. I want that.”
Now, as investment professionals, we know they would do better if they went down the roster of choices and found a strategy, a fund or an asset class and said, “Oh this has been really lousy for one year, three years and five years, and its expense ratio is low, and the manager or the strategy is true to its discipline. It's probably ready for a turn. Let me put my money there.” Does one person in a thousand think that way?
No.
And yet instinctively, as investors, we know that people who do think that way will have better results.
We're in the only major business in the global macro economy in which the higher the price of the asset, the more popular it is. In which bargains are shunned. In which the price gets knocked down 20% and the customer says, “Get me out of here!” In which the price goes up 50%, and the customer says, “Can I have more of this please?”
Human nature conditions us to chase what has performed best. What has performed best feels good. And yet any student of the market knows that's a dumb way to invest.
