Investors need to scale back their performance outlooks for stocks and bonds as a “3D Hurricane” of deficit, debt and demographics weigh on global markets, Research Affiliates chairman and founder Robert Arnott said Wednesday at the 2013 ETF Virtual Summit.
“There are daunting headwinds coming our way,” he said. “This is going to be an interesting storm.”
Arnott outlined an “expectations gap” among investors who are looking for stock returns of 12% a year and bond returns of 9% annually based on historical performance.
“People need to ratchet down return expectations,” he said at the ETF virtual conference Wednesday. “Low returns aren’t dangerous but expecting big returns and not saving enough is dangerous.”
Looking ahead, Arnott said more realistic returns in bonds are 4% annually, and between 4% and 6% in stocks, due to spiraling debts and deficits in developed economies, as well as unfavorable demographics as the population ages.
Inflation, which is understated by the Consumer Price Index, will also take a bite, he said.
Including unfunded liabilities such as Medicare, Arnott estimates the debt-to-GDP ratio in the U.S. is “unsustainable” at just shy of 600%.
Meanwhile, demographics are switching to a headwind to a tailwind as the proportion of senior citizens to working-age people goes to 20% the next few years, he said.
Although investors are faced with a difficult environment, there are steps they can take to weather the storm, Arnott said.
He suggested looking at alternative asset classes outside of U.S. stocks and bonds. Investors can consider emerging markets, which have lower valuations and higher dividends.
Also, they need to save more, spend less, and plan on working a couple years longer before retiring.
Arnott, who previously served as editor of the Financial Analysts Journal, is best known for developing benchmarks that weight stocks by fundamental factors rather than by market cap.
Invesco PowerShares manages several ETFs hitched to FTSE RAFI benchmarks, such as PowerShares FTSE RAFI US 1000 Portfolio (PRF). RAFI stands for Research Affiliates Fundamental Index. ProShares sponsors ProShares RAFI Long/Short (RALS). [Fundamental Indexing Quiets Its Critics]
Fundamental indexing is an approach that avoids weighting companies by market cap like most traditional stock benchmarks, Arnott explained.
Market-cap-weighted indices mirror the market but their “Achilles’ heel” is that the most money is allocated to the most-loved companies with the highest stock price, or the stocks with the greatest growth expectations and loftiest valuations, he asserted.
“Why not index companies based on how good their business is?” Arnott said.
He said fundamental indexing weights companies by their economic footprint and creates a value tilt relative to the market. Also, the indices are constantly re-weighted, which takes advantage of premiums and discounts in the market to economic footprint.
Fundamental indexing “turns volatility into incremental return,” Arnott explained. Boosting returns by a couple percentage points annually with the approach can make a “big difference” over 20 years, he said.
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