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By Scott Burns | 09-22-2011 01:18 PM

Arnott: Look Outside Mainstream Stocks and Bonds

Investors need to broaden their horizons and consider alternatives and tactical bets if they want to achieve respectable returns in the coming years, says Research Affiliates' Rob Arnott.

Burns: Now how do people invest? With the 3-Ds out there? What do we have to do?

Arnott: As an American citizen, I am alarmed and depressed about the path that we've been on and the path that we are on. I think we're pursuing very, very dangerous policies and market action of the last couple of days suggests that there is not a whole lot of enthusiasm for Federal Reserve chairman Ben Bernanke's latest great idea (Operation Twist).

Burns: Twister II, that's what I call it.

Arnott: Well, it didn't work for Kennedy; it's not going to work for Bernanke. As an investor I look on this as a really interesting and challenging puzzle. You've got a low-yield environment; bonds yield 2%-3%. If you take enough duration risk and enough credit risk, you can get up to 4% or little higher, but 2%-4% is really your range for fixed income. For stocks, you're getting a 2% yield, and history says 4% earnings and dividend growth, making a total of 6%. But that's absent the headwinds. History didn't have these headwinds, so maybe it's 3%, maybe it's 2%. That gets you to the 4%-6% range for stocks.

If you're getting 2%-4% for bonds and 4%-6% for stocks, you're looking at four and change for the classic balanced portfolio. So what do you do? Look outside, of mainstream stocks and bonds; there is a whole spectrum of alternatives out there. Some of them, at any given time, are going to be more attractive than mainstream stocks of bonds. Look to those asset classes to boost your return. Look to those asset classes to tamp down your risk because of low correlations, and then look for alpha. Try to identify ideas that, instead of siphoning return away through fees and implementation costs, can actually add something. The Research Affiliates Fundamental Index is a beautiful example of that. Historically, it's added in long-term back tests 2%-4% in developed markets and live experience 1%-2% in developed markets in the face of a headwind with values severely underperforming.

Burns: Right. I think in your presentation, you laid it out: The critics said this, then this happened.

Arnott: Yeah.

Burns: So the critics said fundamentally, it's the just a value tilt.

Arnott: So, now you have five years in which value underperformed by 1%-2% and the RAFI outperformed by 1%-2%. Now what do you say Mr. Critic?

Burns: Right.

Arnott: The other criticism is "It is just a back test." OK, now, it's not. It's now live. The other observation is the less efficient the market, the more value is added. So, we find that it adds more value in small companies and more value in emerging-markets countries. Where are the opportunities in the years ahead? They're probably in small companies and emerging markets. Wonderful. So, the toolkit is broaden your horizons, look outside of mainstream, look for alpha, where you can find it, and be tactical.

Move money out of markets that are popular and trendy because popular and trendy doesn't mean profitable. It means the market loves these assets and prices them to reflect the very low demand for forward-looking returns. You should move that money into markets that are out-of-favor even ones that are feared and loathed, because those are the markets where people demand a premium return.

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