The key tonic to the past 10 years was a more diversified, less equity-centric approach. A risk premium over government bonds 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 portfolio 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).
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.
The above is an excerpt from the monthly commentary of Robert Arnott, Chairman of Research Affiliates LLC, which was released today. To read the full commentary, please click here.
