Patience Helps In Low-Return World

September 11, 2008

Why adhering to specific tenets will help earn meaningful returns in today's global tactical asset allocation environment.


Global tactical asset allocation (GTAA) is confused by many investors with market timing. Market timing, shunned by nearly all individual investors and many institutions, involves picking market tops and bottoms and, based on that information, making dramatic short-term shifts in asset-class exposures. Needless to say, the successful market timer must have remarkable clairvoyance. The variables that can heavily influence market returns over the short term—that is, a day, a week, a month, even a year—are practically limitless. And when the market timer is wrong, any performance advantage, especially in relation to peers and benchmarks, quickly evaporates.

GTAA is different: It involves seeking to bear risk when risk is likely to be rewarded but moving to a conservative, diversified posture when it is not. Today, despite a sharp sell-off in many risky assets during the past year, the pendulum in the market remains on the risk side, not on the return side. In the last bear market, many investors thought they saw wonderful opportunities a year too early, in 2001, but significant return opportunities did not abound until late 2002. Today, patience is the key to eventually reaping meaningful profits.

The Research Affiliates GTAA process begins with building a long-term forecast that anchors portfolio allocations amid the short-term noise of the markets. These projections start with the simple premise that asset-class returns come from three distinct sources: income, growth in income, and changes in valuations.

The first source, income, is obviously the largest driver of bond returns. But many investors are surprised to learn that since 1926, income from dividends has also been the largest contributor to stock returns—and the dominant source of real equity returns net of inflation.[1]

For bonds, with income "fixed," growth in income is, by definition, zero. Indeed, it is actually negative for most bond categories because occasional defaults inevitably take a bite out of the higher coupons. Equities, however, have positive expected income growth; that is, earnings that fund dividends grow along with the real economy. The rate of income growth, positive or negative, depends greatly on the economic and market environment, but the growth rate tends to revert back to a long-term average over time.

Finally, changes in valuations occur because investors may pay more or less for an asset class in 5 or 10 years. Changes in valuations over the short term (up to a few years) are the most volatile and difficult to predict, and they can be the dominant source of positive or negative returns. But for spans of a decade or more, this component of returns diminishes in significance.

Because income and dividends comprise the lion's share of long-term asset-class returns, let's examine these elements in today's market. Table 1 provides yields for eight asset classes as of July 2008 and March 2002.[2] Across the board, bond and alternative categories offered much more competitive yields in 2002 than they do today. Only U.S. equities offer a yield premium (2.3% versus 1.4%), but one could argue that this premium is hardly a bullish figure, because today's current yield is virtually half of the long-term 4.4% contribution of dividends to stock market returns.[3]


Table: Yields During Last Two Bear Markets


We have combined these asset classes into efficient frontiers of portfolio choices in Figure 1 to reflect the overall risk/reward opportunities in the two bear markets.[4] In this analysis, income yields are combined with the other two sources of portfolio returns—namely, projected growth of income and changes in valuations.


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