Rob Arnott: 10-Year Returns Look Grim

AMSTERDAM – Investment legend Rob Arnott gave investors a gloomy forecast for medium-term returns at the Inside ETFs Europe conference today, and urged the audience to think of a new way to track the market.

The chairman and CEO of Research Affiliates said 10-year forward-looking expected returns are unanimously low. Core fixed-income stands at 0.5 percent real returns as well as long-dated inflation linked bonds. Long Treasuries will go barely above zero. U.S. equities are 1 percent above inflation, and small-caps also give 1 percent, despite their yield of 1.8 percent.

“Growth of earnings and dividends over and above inflation is 1.3 percent, not the 5 percent or more that Wall Street wants us to believe,” said Arnott.

Very Different Markets

“We are looking at very different markets: inflation-linked bonds, equities, REITs, ordinary bonds, all in the zero-to-one real-return range on a 10-year basis. Yikes! That’s grim. And that’s before fees have been taken into consideration,” he added.

These markets have all gone through an enormous bull market, which leaves investors with “lousy” forward expectations of returns, according to Arnott.

“And where are most ETFs invested today?” he said. “In mainstream markets.”

Some investors argue they may be willing pay more for alpha-generating active funds, but Arnott encouraged investors to look at how much of that alpha the active manager passes back to the client.

Alpha Deficit

RAFI research found that the U.S. top-quartile active manager pockets 0.9371 percent and only passes on 0.0629 percent on to the client, whereas with a U.S. Fundamental Indexing strategy, the client gets the lion’s share, at 0.7909 percent, and the issuer takes back 0.2091 percent.

Arnott said investors should therefore pick a passive fund that severs the link with price and valuation, and to avoid market-cap weighting, particularly in fixed income and commodities.

This “smart beta,” although it has a nebulous definition, should capture most of the advantages of indexing: low cost, transparency, ability to backtest, low turnover, broad representation spanning the macroeconomy, and it should also sever the link between value and price.

However, Arnott warned that the industry should not just produce products that address what clients want rather than what they need, as this would not ultimately benefit the end investor in the long run.

“It’s this lemming behavior of chasing what’s hot and shunning what’s disappointing that funds the success of contrarian strategies,” he said. “And what are smart-beta strategies? They are inherently contrarian.”