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New Roads to Excess Return
10/09/2007 12:00 am EST
Robert Arnott, chairman of Research Affiliates, gave attendees a comprehensive tutorial on the Capital Asset Pricing Model and the different ways that academicians define intrinsic and fair value.
Arnott discussed how random noises–or pricing errors–can offer opportunities in markets by causing a gap between intrinsic values and market prices.
He summarized historical equity returns and yields, as well as bond yields, and told attendees that due to lower current yields, investors must trim expectations of future equity returns by 2-3%, to about a 3% real return. That measures up to some 1% above the 2% real return he expects bonds to deliver–very near current levels.
Consequently, Arnott suggested that investors may want to consider other asset classes, particularly as unconventional or out-of-favor assets can be priced to offer better returns. He also recommended two other paths to greater returns: seeking alpha (earning returns in excess of the market’s) and actively managing your asset mix. Arnott cautioned investors that a fourth alternative–leverage–boosts risk far more than it improves prospective returns.
Arnott discussed traditional capitalization-weighted indexing, like the Standard & Poor’s 500 in which stocks’ contribution to an index is determined by their market capitalization. He pointed out that the theory is optimal in equilibrium, and has positive attributes such as liquidity, capacity and low cost.
However, empirically, it has shown itself to be vulnerable to pricing bubbles and subsequent corrections, resulting in overweighting overvalued stocks and underweighting undervalued equities. (For example, high-flying Internet and telecom stocks arguably amplified the rise and fall of the S&P 500 during the dot.com boom and bust.)
Instead, he has created an equity index of 1,000 stocks selected, ranked and weighted by fundamental factors such as book value or revenues. Arnott noted that this is a valuation-indifferent index and strips away linkage between portfolio weight and any over- or undervaluation.
He wrapped up his presentation by demonstrating to attendees the efficacy of his index in value versus growth markets, as well as in domestic, international and emerging markets.
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