We see a silver lining in the aftermath of 2008: The global meltdown in virtually all risky assets has finally brought long-term return expectations to attractive levels. As we have stated in the past, dividend yields comprise the lion's share of stock market returns over long time periods. As of February 27, 2009, the dividend yield on the S&P 500 Index was 3.9%, the highest since the recession in the fall of 1990. This figure is also very close to the historic return from dividends as shown in Figure 1. The premium for bearing market risk (as measured by equity dividend yields) is finally in line with the historical average. If it "pays" to be a long-term investor, isn't it time to take a hard look at equities again?
We believe that last year's disappointment with active management will likely reignite the active-passive debate in investment circles, and that many investors will come down on the side of passive management. In short, we believe investors will favor simplicity over complexity, lower fees over higher fees, liquidity over lockups, and transparency over opacity. Beta exposure can get most investors in the ballpark of their long-term return targets, without the risks and costs of active management. The recent headlines will accelerate this trend. How many times has an index fund been indicted for a multibillion-dollar fraud? If investors progressively embrace this view, their allocation to index funds will rise as should their scrutiny on the way these indexes are constructed.
In summary, we believe the recent investment disappointment combined with (finally) reasonable attractive equity valuations suggests advisors and investment committees would be well served to revisit their allocation to passive equity strategies in their portfolios.
- Using the S&P 500 for stocks and the BarCap Aggregate for bonds.
- Source: eVestment Alliance. Returns are gross of management fees. Peer group data is notorious for biases, chief among them survivorship bias. Typically, trailing data only includes those products that were still in existence at the end period. Thus, it is only a snapshot of survivors who we can only predict had better performance than the funds that went the way of the dodo bird! eVestment Alliance partially protects against this bias as it still includes calendar year returns for "inactive" funds. The other primary bias embedded in this type of data is backfill bias, where a presumably strong performing manager can enter in previous calendar years when they begin entering regular data to the databases. In short, the historical data analyzed since 1990 is probably being overly generous to active manager performance.
- The portfolio is broken down as follows: 20% large core, 10% large value, 10% large growth, 10% small-cap, 10% international equity for a total of 60% equity; and 40% core plus fixed-income.
- We will not explore the impact of fees on net performance in this issue beyond noting the fact that the cumulative impact of fees on performance can be substantial.
- "Patience Helps in Low-Return World," RAFI Fundamentals (September 2008).
© Research Affiliates®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.
JOHN WEST, CFA, Associate Director, Marketing & Affiliate Relations of Research Affiliates, LLC