Bernstein: Big Bond Investors Blew It

January 12, 2018

Richard BernsteinRichard Bernstein is chief executive officer and chief investment officer of the firm that bears his name. Richard Bernstein Advisors is known for its top-down approach that focuses on macro trends. Bernstein is one of the panelists at Inside ETFs Jan. 21-24 in Florida for the discussion “Where to Invest for the Next 3 Years.” caught up with him for a preconference chat. The topic of the round table you’re participating in is where to invest for the next three years. Would give us a rundown of what you’ll talk about in that panel?

Bernstein: My main topic that I’ve been talking a lot about in the last three or four months is that people have completely mis-assessed risk—in any number of different ways.

First of all, what they’ve completely ignored—because they’re so worried about 2008 coming back still—is the opportunity cost of not being in the equity market. In our report, we pointed out that, in the last five years, stocks have outperformed bonds by 15% per year—that’s a monstrous fee to pay for protection.

I can’t believe more people aren’t asking, how can pension funds be underfunded when we’ve had the second-longest bull market in history? The answer is, because they haven’t had a correct allocation to equities. They, like everybody else, have been scared that 2008 was going to come back. It’s not just individuals; it’s really pretty widespread.

Why are people still investing with absolute-return hedge funds during a bull market? It just doesn’t make any sense. It’s because they’re sure that 2008 is coming back. When you talk about whether it’s one year, three years, five years or 10 years, people have to be much more dispassionate about assessing perspective, expected returns and risk. It’s amazing that it’s still influencing asset allocations. That’s No. 1.

No. 2 is that people have set asset allocations, assigning very high probabilities to low-probability events. And what I mean by that is, there’s a report by one of the brokerage firms toward the end of last year that identified eight different black swans.

I thought that was hysterical. Because, No. 1, a black swan is supposed to be something you’re not supposed to be able to identify. No. 2 is they found eight of them. And No. 3 is that the whole point of the report was how to structure a portfolio given the possibility of these eight things occurring. By definition, a black swan is supposed to have something less than a 1% probability. Why in the world would you structure a portfolio for something that has less than a 1% probability of occurrence?

Recently people have asked me, “Don’t you think the risk of war in Korea is higher?” And my answer is, “Of course it is. But maybe it’s gone from 0.5% to 2 or 4%.” However, what’s the probability over the last six months or so—when people have been asking me these questions—that the Korean earnings were going to come in better than people thought? We assess that to be more like 75% probability.

Do I structure a portfolio for 1% probabilities, or do I structure a portfolio for 75% probabilities? So this is something you see happening in the wider investing population?

Bernstein: Look at mutual funds and ETF funds flows, and you can see it. It’s only been very recently that equities have begun to outpace bonds. That would be No. 1—the misallocation of assets.

No. 2 for me would be that people have ignored and are ignoring and, my guess, will ignore inflation risk. Everybody says, oh, people have been waiting for inflation to come back forever and nothing is happening. That is just completely untrue. That’s bond investors trying to rationalize why they won’t buy anything but bonds.

If you look at bond returns since inflation expectations troughed—which was actually in 2016—what you’ll find is bonds have returned about 1% total, not 1% per year. And stocks have returned about 35%.

This notion that inflation is not a risk, is not affecting anything and we should ignore it, just isn’t true. The bond market has been having a lot of trouble even in the face of what people were seeing to be no threat from inflation. If you’re looking for something that could bite people in the tush, that could be it. Right now you’re bullish on the market.

Bernstein: Bullish on the equity market. We have pretty close to the highest equity allocation we can have in our portfolios for equities. We have the lowest, fixed-income allocation we can have. And what fixed income we have is extraordinarily short duration.


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