William Bernstein: Be Open To New Factor Tilts

July 02, 2013

In the hurly-burly of a transition to a post-Fed world, stay focused on timeless asset allocation discipline and on truly new ideas in the realm of factor-based investing, Bill Bernstein says.


The transition toward a world of higher—and more historically normal—interest rates seems to have reared its head in the past several weeks following Federal Reserve Chairman Ben Bernanke’s comments that the U.S. central bank may well begin “tapering” its latest bond-buying program, investor, former neurologist and author William Bernstein says.

But in the confusing, sometimes emotionally reactive tumult that is accompanying this shift to a world no longer dependent on the Fed’s economic life support, Bernstein told IndexUniverse.com Managing Editor Olly Ludwig that it’s crucial for investors to remain loyal to time-tested rules about asset allocation discipline.

William Bernstein—whose latest book “Masters of the Word: How Media Shaped History from the Alphabet to the Internet” strays ably and incisively from the many well-crafted books on passive investing he is known for—also stressed that investors ought to stay open to what’s truly new and significant, such as the emergence of factor-based approaches to investment, including profitability and momentum.


IndexUniverse.com: Whatever’s going on in the market, you might finally be right—four years later!

Bernstein: That’s right—better late than never! Fortunately, I wasn’t invested in a risk-parity portfolio before this.

IU.com: You’ve got to be pleased you’re not in some kind of scramble right now. This dislocation in the market seems a bit surprising. Whatever this mean reversion is, it seems like it’s possibly taking shape.

Bernstein: Oh yes. The analogy that I like—it’s not original to me, but it’s one that I like very much—is that the Fed has basically been holding a basketball under water for the past four years. And we know what historical interest rates look like. When the Fed lets go of that basketball, it should not be surprising that it moves in an upward direction.

IU.com: What strikes me is that there appears to be a lot of surprise, and I’m not sure what to make of that.

Bernstein: Never underestimate the power of financial amnesia. That is a charitable way of putting it, or some people are historically illiterate. Bond markets do crash from time to time.



IU.com: So how do you see this playing out? Is there a possibility of a relatively serious inflationary episode playing out?

Bernstein: It’s always possible. The bottom line is that there will be inflation when the money supply grows dramatically, and that’s not happening. And the reason it’s not happening is that all the money that’s being printed by the Fed that’s growing rapidly is pretty precisely balanced against the collapse of credit—the bank money, which is the vast amount of money that’s in circulation at any one time, of course.

IU.com: And how that resolves is not yet clear, is what you’re saying?

Bernstein: I could tell you that I knew, but I’d be lying. We’re in terra nova. I don’t think anyone really knows the answer to this and how it plays out. And if we get inflation, the real question is, How does the Fed respond? If we have someone with Paul Volcker’s iron will, then we have nothing to worry about. We get tight money, which is good for investors—especially fixed-income investors, short-term fixed investors, I should say. And it’s good for the economy in the long run. And if we get someone who’s weak-willed—an Arthur Burns—then we’re in trouble.

IU.com: You’ve talked about making peace with Treasury bills in the here and now. Is that still how you see the fixed-income portion of a portfolio at this juncture, when there seems to be signs of some sort of reversion to the mean?

Bernstein: This reversion to the mean is basically at the middle part of the yield curve. Long rates haven’t increased that dramatically, and short-term rates haven’t budged at all because the Fed is still holding the basketball under water.

IU.com: I can hear some people saying, “Don’t be so sure this basketball is going to rush to the surface.” This financial repression may well be with us for longer than many of us think, and that even after the events of the last month, when the Fed has changed its posturing, you can still hold your breath. What do you think of that?

Bernstein: I think it smacks of “This time it’s different.” And sometimes things are different. And things have been different in Japan in the past 20 years. But I don’t think we’re Japan. I think we’re better at cleaning our books, writing things off. The reason I think Japan has suffered such a prolonged period of deflation is because it hasn’t recognized its bad loans.

IU.com: That still remains the case, is what you’re saying?

Bernstein: Yes.

IU.com: So, short-term T-bills remain appropriate on the fixed-income side, and on the equities side, would you hew to the classic broad-market passive investment frames of reference you’ve long embraced?

Bernstein: Yes, but I’ve always believed in factor tilts. And there are some new factors. There’s profitability and momentum, and I think those will hold a premium in the future.



IU.com: So you think they’ll be embraced by serious-minded investors and that they’ll enjoy a popularization?

Bernstein: I think so. If you look at the history of the public appreciation of the “value” factor and the “small” factor in the aftermath of the Fama-French factor in June 1992, what you saw is that from 1992 to 2000, if you invested in a tilted portfolio, you got hammered relative to the broad market.

But now, 20 years later, all around the world, Fama-French looks pretty good. If you had a small-value tilt for the past 20 years and you saved a reasonable amount of money, you’re on Easy Street right now.

I think the same thing will be true going forward with the newer risk factors, like profitability and momentum. You can identify a risk factor, you can invest in it, but 90 percent of people are going to bail on that approach in the rough patches, like what happened in the late ’90s with value and small investing, and that’s when the real money was made.

But there’s nothing wrong with just owning the market. But what’s more important than anything else is not how much tilt you have, but how disciplined you are in keeping your overall stock-bond allocation in place.

When I think of equity markets, I think it’s three basic asset classes: U.S. stocks, developed market stocks and emerging markets stocks. I currently see the U.S. markets as somewhat expensive—not horribly expensive. But I see developed market stocks and emerging market stocks now as being slightly cheap.

So, if you have a desire to tilt away from your usual allocation from a market portfolio, I don’t think there’s anything wrong with being heavy foreign stocks right now.

IU.com: You’re open to developed and emerging market stocks because of what’s been going on in those two pockets of the investment universe?

Bernstein: Right. You’ve seen Jason Zweig’s latest column? It’s the one he wrote after getting the Gerald Loeb Award. It’s a beautiful column. The implicit message there is that “naive contrarianism” that is usually spat out as an epithet usually works. When an asset class has been trashed for five or 10 years, it’s probably going to be better than average going forward.

IU.com: So between what people are saying about what’s going on in Western Europe and saying the bloom is off the rose in emerging markets, that’s when you start smelling opportunity?

Bernstein: Yes. And God bless Ron Paul—precious metals equities as well.

IU.com: I have a feeling you may say answering this question may be above your pay grade, but the Fed seems to be optimistic about economic data painting a picture of economic improvement in the U.S. Do you take the Fed at its word as it amends its policy posture, or do you think it’s guilty of wishful thinking? How do you see this shifting message out of the Bernanke Fed?

Bernstein: Thank you for answering that question for me ahead of time—I would never want to second-guess the former chairman of the economics department at Princeton and the authority on the Great Depression. I take him at his word.



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