Diversify Beyond Stocks, Bonds, Pimco Says

NEW YORK (TheStreet) -- Robert Arnott, manager of the Pimco All Asset Fund (PASAX), made waves in spring 2009 when the stock market was hitting bottom. He noted that bonds had outperformed stocks during the previous 40 years. Investors should be wary about relying heavily on stocks, he said.

Critics dismissed Arnott, saying the poor showing of stocks was a fluke. But Arnott is sticking to his guns. Speaking at the recent Morningstar Investment Conference, he retraced market history and argued that stocks could fare poorly in the coming decades. "The idea that stocks beat bonds by 5% per year is simply not true," he said.

Most investors have expected stocks to outdo bonds over long periods. Confidence in stocks has been based on the famous data generated by Ibbotson Associates. During the period from 1926 through 2009, large stocks returned 9.8% annually, while intermediate government bonds returned 5.3%, according to Ibbotson.

Arnott bases his pessimistic view on market history going back 200 years. During that time, stocks have outpaced bonds by about 2.5% annually, he said. But there were very long periods when stocks lagged bonds. "If you bought stocks in 1803, you would be behind bonds for the next 68 years," he said.

In recent years, there have been many periods when bonds kept pace with stocks. Since 1968, stocks and bonds have produced similar returns, Arnott said. While stocks have generally risen over the past two centuries, there have been many 10-year periods when equities stagnated.

How will investors fare in the next decade? Arnott says both stocks and bonds will likely produce subpar results because the current yields are low, an indication that prices are rich.

Bonds yield 4%, so investors should expect to get annual returns of around 4%, Arnott said. Stocks may not do better. He said stocks began the 1990s with a dividend yield of 6%, a sign of reasonable valuation. But when share prices rise, dividend yields fall. As the greatest bull market in history unfolded, dividend yields dropped, reaching a meager 1% in 2000. At that point, dividend yields were at all-time lows and price-to-earnings ratios were at record highs. With stocks expensive, it was not surprising that the S&P 500 languished in the past decade.

Now the dividend yield has risen to 2%, a sign that the market is still expensive, says Arnott. "Dividend yields are twice what they were 10 years ago, but half of what they have been on average over the past 100 years," he said.

To avoid dismal returns, investors need to diversify broadly outside stocks and bonds. Such a strategy would have produced solid results during the past decade. To demonstrate his point, Arnott calculated the returns for 16 asset classes during the 10 years ending in 2009. While the S&P 500 lost 1% annually during the period, all the other assets stayed in the black. Investments that produced more than 7% annual returns included emerging-market stocks, Treasuries and commodities.

Arnott argues that part of the reason the S&P 500 did so poorly is because stocks in the index are weighted according to their market capitalization. Under this system, stocks with bigger market values account for a larger weight in the index. As hot stocks grow, they have a greater impact on index returns.

Before markets collapsed in 2000, values soared for stocks in technology, media and telecommunications. The three sectors accounted for 50% of world market capitalizations, even though the businesses only produced 20% of economic activity. When the Internet bubble burst, the hot sectors sank and dragged down the S&P 500. Market weighting produced a different problem during 2009. With investors in a panic, markets undervalued certain sectors, including industrials, consumer discretionary and financials. Although the sectors produced 55% of global economic activity, they only accounted for 25% of market capitalization. So when the depressed sectors soared, the S&P 500 was underweight some of the best performers.

Arnott argues that investors could have done better by relying on funds that track the equal-weighted S&P 500 Index. The index gives an equal weight to every S&P stock. Because it does not overweight hot sectors, the index managed to return 5% during the past decade.

Arnott says that investors may do better in the future by using a fundamental index, such as the FTSE-RAFI All World 3000, which he designed. The fundamental benchmarks weight stocks according to sales and other measures, not market capitalization.

While some analysts dismiss the past 10 years as a lost decade, Arnott said investors should not view the period that way. "It was a lost decade for capitalization weighting," he said. "It was not a lost decade for stocks."

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Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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