Total time: 10:03
Sage Advisory: Hello, we're here at the Sage Perspectives on the Future Conference with Brandon Kunz, Partner and Portfolio Specialist at Research Affiliates. He just presented to our conference on a presentation titled “The Past is Not Prologue.” And so, Brandon can you first just introduce yourself, talk a little bit about Research Affiliates. We’ve been used to good returns on U.S. assets, really financial assets over the last, you know, century plus. Talk a little bit about – can we be expecting this in the future?
0:33
Brandon Kunz: Yeah, so, just quickly on me, I'm from California, I’ve been working with Research Affiliates for about six years on their multi-asset strategies. We partner with a couple of affiliates on a tactical asset allocation vehicle and then another all-risk premium fund. And our business model is just conducting research and then affiliating with asset managers to distribute the solutions based upon our research. So, in order for us to really add value, we have to provide compelling research and a compelling investment process that other asset managers want to exploit. As it relates to high returns experience in the past and what the future looks like – we have found through our work that yield is a primary driver of returns for most asset classes, and yields across all asset classes over the last 10 years in particular has fallen pretty significantly to the point where we now forecast a U.S.-centric 60/40 portfolio to deliver very modest returns. If you look at, for example, U.S. stocks, our nominal return forecasts can be computed with a building blocks approach, where we look at different components of the drivers of return, and the starting yield is about 1.8% for U.S. stocks – that’s the dividend yield. Our expectations for real earnings growth is something to the tune of 1.3%. That gets you to 3.1% real. You add about 2.1% for inflation, and that gets you to something like 5.2% nominal returns, and that's assuming that today's valuations remain elevated. If you get any mean reversion in valuations, then that starts to eat away at that 5.2% nominal number. And based upon our assumption, that valuations revert just halfway back to long-term averages, then that can represent about a 3% return headwind to the returns of U.S. equities. You put that all together, you get nominal returns of around 2%-ish, and real returns of very close to zero. And it doesn't look any better for bonds. So regardless of the way that you slice it, a U.S. 60/40 portfolio is looking like its central tendency returns are going to be in the sub-one range.
2:47
Sage Advisory: So, you mentioned valuation reversion – can you talk a little bit about what you mean by valuation and your method on thinking about valuation just starting with equity markets?
Brandon Kunz: Yeah, so we look at valuation using a metric that we believe is the only predictive metric of returns in the valuation land. There are a couple derivations there, but it's the Shiller P/E ratio, also known as the CAPE ratio. And basically, what we're doing is looking at today's price divided by 10-year real earnings, the average of the 10-year real earnings over the last decade. And by doing that, you can actually create a longer-term forecast, not something that's good for tactical one-year time horizons, but something that's certainly accurate over 10 and longer periods of time, as it relates to what return prospects are likely coming out of really all equity markets. It's not just the U.S. And so, if you look at that valuation where today, the U.S. Shiller P/E ratio is close to 30 times earnings. In other words, an investor today has to pay about $30 for every dollar of real smooth earnings coming from the equity market, and on average, it's been much lower than that historically. Now, we don't assume that we will revert from today's high Shiller P/E ratio of 30 all the way back to that long-term average. But we do assume with our evaluation work that we will revert at least partially towards that longer-term average. And if we assume that it just goes halfway back to that long-term average, then that is indicative of what I was mentioning 3% return headwind, to the returns of U.S. equities. And you can apply this analysis to any country or any region, and interestingly, outside of the U.S., you don't get those same effects. In emerging markets, for example, they're trading at Shiller P/E ratios of close to 13 times earnings. And our assumed equilibrium is a little bit higher than that, something closer to 14 times earnings. So, there's room for multiple expansion in emerging markets. In developed markets, there's not necessarily room for multiple expansion or contraction, it's just that the dividend yields and the earnings growth added up together with the potential for a currency appreciation lead to our assigning kind of real returns for non-U.S. developed exposure of something like 4.5% or 5.5% per annum for the next decade on a real basis.
5:21
Sage Advisory: Interesting. You mentioned emerging and developed markets. I know that demographics and your analysis and research in that area play a huge role into future expected return. Can you elaborate on that a little bit?
Brandon Kunz: Yeah. So basically, our demographic work speaks to the potential for real earnings growth prospects across different regions. And in areas where you have relatively young populations, it's usually the case that younger populations are learning quicker. And if they're learning quicker then they're contributing more to productivity growth, and thereby real GDP growth within that particular economy. And that can flow through to not just the real earnings growth coming out of the equity market, but also to cash rates, which is a way to capture what real interest rates ought to be in a particular country, which tend to be related with long-term GDP growth. So, if you have countries that have younger populations that have higher productivity growth, and those populations are growing, then those countries ultimately have higher cash rates and the potential for higher growth in dividends and earnings per share. As a result, we assign higher return prospects to emerging market countries that are expected to have higher equilibrium cash rates moving forward relative to their developed market counterparts.
6:48
Sage Advisory: Interesting. What about factor investing – does it hold the answers? What should we be looking at in terms of factors?
Brandon Kunz: Well, we've written a couple of papers that kind of try to disentangle which factors are robust. There's been a lot of different articles out there that say that there are hundreds and hundreds of different factors. In the era of artificial intelligence and machine learning, you can have computers find a t-stat of anything on any spurious relationship, and that could give you the sense that there's more robust factors than there really are. For us, I think the most important thing is identifying which factors are robust, and that requires putting each factor through a pretty stringent test. From our standpoint, it's best to recognize which factors are robust, and then identify which factors are increasingly cheap relative to their average valuations. And those factors that are increasingly cheap are the ones that you most likely will want to leg into, relative to others that are increasingly expensive. There's a momentum consideration that we can add to that as well, where we look at whether or not a factor has had recent momentum in its returns. And if you use a combination of both factor valuations and factor momentum applied to robust factors overall, then that could be a decent portfolio relative to kind of a passive capitalization weighted approach to equity investing.
8:17
Sage Advisory: Okay, so Brandon, last question. You know, we can expect lower returns in the coming years, especially long term from asset classes. We're getting older as a population on a global basis, you know, what do investors do in this coming environment? And how do they maximize the probability of earning, let's say a 5% real return?
Brandon Kunz: This comes down to increasing your tolerance for what we call Maverick risk. Most people are so afraid to deviate from the allocations of their peers that they're unwilling to succeed or fail unconventionally. And in order to succeed in the coming environment, we see a growing need to allocate to unconventional asset classes, diversifiers, asset classes that tend to be satellite positions in most investors’ portfolios. Those are the asset classes that are poised for better performance. We also have noticed that most investor portfolios are under-allocated to alternative forms of risk premium. Think carry investing globally or value investing globally, but more in a long short format, or trend investing globally, where you buy trending markets and sell markets that are selling off. If you do that in a robust portfolio, then you're gaining access to alternative forms of premia that are uncorrelated to traditional asset class exposure. And if appropriately leveraged and managed, they can be poised to deliver returns of, say, cash plus 7% to 9% over a full market cycle, which is certainly more attractive than the less than 1% real returns that a 60/40 portfolio is offering today.
9:59
Sage Advisory: All right, thank you for your time today, Brandon.
Brandon Kunz: You're welcome. Thank you for having me.
