We manage assets in an equity-centric world. In the pages of the Wall Street Journal, Financial Times and other financial presses, we see endless comparisons of the best equity funds, value funds, growth funds, large-cap funds, mid-cap funds, small-cap funds, international equity funds, sector funds, international regional funds and so forth. Balanced funds get some grudging acknowledgment. Bond funds are treated almost as the dull cousin, hidden in the attic.
This is no indictment of the financial press. They deliver the information that their readers demand, and bonds are—at first blush—less interesting. The same holds true for 401(k) offerings, which are overwhelmingly equity-centric. If 80–90 percent of the offerings provided to our employees are equity market strategies, is it any surprise that 80–90 percent of their assets are invested in stocks? And is it any surprise that they now feel angry and misled?
Many cherished myths drive our industry’s equity-centric worldview. The events of 2008 are shining a spotlight, for professionals and retail investors alike, on the folly of relying on false dogma.
- For the long-term investor, stocks are supposed to add 5 percent per year over bonds. They don’t. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market.
- For the long-term investor, stock markets are supposed to give us steady gains, interrupted by periodic bear markets and occasional jolts like 1987 or 2008. The opposite—long periods of disappointment, interrupted by some wonderful gains—appears to be more accurate.
- For the long-term investor, mainstream bonds are supposed to reduce our risk and provide useful diversification, which can improve our long-term risk-adjusted returns. While they clearly reduce our risk, there are far more powerful ways to achieve true diversification—and many of them are out-of-mainstream segments of the bond market.
- Capitalization weighting is supposed to be the best way to construct a portfolio, whether for stocks or for bonds. The historical evidence is pretty solidly to the contrary.
As investors become increasingly aware that the conventional wisdom of modern investing is largely myth and urban legend, there will be growing demand for new ideas, and for more choices.
Why are there so many equity market mutual funds, diving into the smallest niche of the world’s stock markets, and so few specialty bond products, commodity products or other alternative market products? Today, investors are still reeling from the devastation of 2008, and the bleak equity results of this entire decade. They have already begun to notice that there were opportunities to earn gains, sometimes handsome gains, in a whole panoply of markets in the past decade—most of which are still difficult for the retail investor to access.
We’re in the early stages of a revolution in the index community, now fast extending into the bond arena. In the pages of this special issue of the Journal of Indexes, we see several elements of that revolution. In the months and years ahead, we will see the division between active and passive management become ever more blurred. We will see the introduction of innovative new products. The spectrum of bond and alternative product for the retail investor will quickly expand. We will shake off our overreliance on dogma. And our industry will be healthier for it.
1) I use the term “risk premium” advisedly. The “risk premium” is the forward-looking difference in expected returns. Differences in observed, realized returns should more properly be called the “excess return.” Many people in the finance community use “risk premium” for both purposes, which creates a serious risk of confusion. I use the term here—wrongly, but deliberately—to draw attention to the fact that the much-vaunted 5 percent risk premium for stocks is at best unreliable and is probably little more than an urban legend of the finance community.
2) Our paper, “The Death of the Risk Premium: Consequences of the 1990’s,” Journal of Portfolio Management, Spring 2001, was actually written in early 2000.
3) For much of this section, we rely on the data that Peter Bernstein and I assembled for “What Risk Premium Is ‘Normal’?” Financial Analysts Journal, March/April 2002. We are indebted to many sources for this data, ranging from Ibbotson Associates, the Cowles Commission, Bill Schwert of the University of Rochester and Robert Shiller of Yale. For the full roster of sources, see the FAJ paper.
4) We used 20-year bonds whenever available. But, in the 1800s, the longest maturities tended to be 10 years. Also, in the 1840s, there was a brief span with no government debt, hence no government bonds. Here, we used railway and canal bonds, which were generally considered the safest bonds at the time, as these projects typically had the tacit support of the government. Think of them as the “Agency,” and GSE bonds of the 19th century.
5) Schwert, G. William, “Indexes of United States Stock Prices from 1802 to 1987.” Journal of Business, vol. 63, no. 3 (July): 399–426.
6) It’s not unlike trying to forecast future stock and bond market returns on the basis of the experience of the current decade. The folly of this exercise is a mirror image of our industry’s reliance on the splendid 1982–2000 experience to shape our return expectations, as far too many investors, actuaries, consultants and accountants actually did in 2000.
7) While it’s simple arithmetic, it bears notice that a 120 percent bull market recovers the damage of a 46 percent bear market with precious little room to spare, amounting to a few tens of basis points a year.
8) Never mind the fact that a passive investment in 20-year Treasuries would have delivered exactly this over the past 40 years!
9) This clearly was not true during the lending bubble of 2005–2007.
10) See Arnott, Hsu, Li, Shepherd, “Valuation Indifferent Weighting for Bonds.” Journal Portfolio Management, pending publication. Please note that there are U.S. and international patents pending on this work; we respectfully request that anyone wishing to explore this idea honor our intellectual property.
11) Because measures like sales and profits are meaningless for sovereign debt, we use a different set of weighting metrics, still in keeping with the spirit of using measures that correspond to the size of the issuer. For countries, we define size using population, area, GDP and energy consumption.