Arnott: Avoid US Stocks, Value In Eastern Europe

May 27, 2014

Rob Arnott is widely considered the "father of fundamental indexing." As chairman and CEO of Research Affiliates, he spearheaded efforts to improve on market-cap-weighted indexes through his Fundamental Index series. Beyond indexing, Arnott is a visionary thinker on the intersection of demographics, academic research and hands-on investing. A six-time winner of the Graham and Dodd Scrolls Award, Arnott has published more than 100 papers pushing forward the edges of financial thinking, and co-authored the book, "The Fundamental Index: A Better Way to Invest."

He sat down recently with to discuss his views on the current fixed-income market and why fundamental indexing makes sense in bonds. Arnott also shared his views on demographic trends, where he sees value in equities, and which markets he's steering clear of at the moment. In late February, you favored emerging market debt, high-yield debt and floating-bank loans. Has your view changed on any of these asset classes since?
Rob Arnott: Our view has become a little more cautious on credit. Credit spreads for high yield, things like floating income, are getting narrower all the time. While there's a fair amount of room for that to continue, they're already thinner than historic norms. I would say our enthusiasm for high yield in all of its various flavors is less than it once was. Why haven't we seen yields rise as expected this year, with the Fed tapering QE? At the start of the year, the 10-year was yielding 3 percent. Now it's at 2.5 percent. Where do you see yields going for the remainder of the year?
Arnott: When you say "why haven't they risen as expected," expected by whom? We have been cautious bond bulls, because our work on demography suggests that the natural real yield on government bonds in U.S. and other major developed economies is roughly zero. This means that unless there is default risk, or perceived risks of inflation, the pressure on bond yields is more likely to be down than up.

I find it fascinating that in a recent survey, 67 out of 67 economists thought rates were going to go up. That was about six or eight weeks ago. Any time you get 100 percent of the market thinking a particular direction is going to happen, they're already positioned for that. There's really no dry powder for the market to respond if the market does the opposite; and the market is likely to do the opposite.

That's where we were and where we are now. If there are inflation threats, rates can go up. If there is a perceived risk of default, rates can go up. Absent those, the natural real rate for governments—given the aging baby boomer population—is roughly zero. The majority of investor focus has been on the equities side regarding the Fundamental Index® strategy. How does the Fundamental Index strategy work in fixed income?
Arnott: Within equities, when you weight a portfolio by market cap, you're putting most of your money in the most popular companies with beloved high multiple companies. That doesn't make sense. When you look at bonds, with cap weighting, you're putting most of your money in the most deeply indebted borrowers. That makes no sense at all, even within a particular quality bracket. If you look at single-A bonds, you're going to still wind up putting most of your money in the single-A bonds offered by those who are most deeply in debt.

Doesn't it make a lot more sense to weight a bond portfolio by the debt service capacity of the borrower? The Fundamental Index method gets you in that direction if you weight a bond portfolio in the corporate arena by a company's sales, profits and gross assets. These are objective measures of company size on dimensions that matter for debt service. If you weight a portfolio on the basis of those measures, you're going to be weighting the portfolio proportional to debt service capacity, not proportional to the appetite for borrowing.

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