Instead of timing the ups and downs, investors should hold stocks for the long run and look to short-duration bonds as portfolio diversifiers, says Zebra Capital Management's Roger Ibbotson.
Christine Benz: Hi, I am Christine Benz for Morningstar.com. What expectations should investors have for the future returns of stocks and bonds? At the Morningstar Institutional Conference, I discussed those topics with Roger Ibbotson. Roger is chairman of Zebra Capital Management, and he is also a professor at the Yale School of Management.
Roger, thank you so much for being here.
Ibbotson: Great to be here.
Benz: In the past, I have asked you to get out your crystal ball and take a look forward to give us your views about expectations for various asset classes. Let's start with U.S. equities. When you look out today, the U.S. equity market has had such a strong run. Do you think that investors should be feeling cautious about U.S. stocks today?
Ibbotson: Well, it's very hard for me to tell you to really dramatically reduce your U.S. stock portfolio. If you look at the long run, it's a big payoff, and I can't tell you exactly when the top is there. Sometimes it doesn't work, but generally I recommend in stocks that you go with them and hold them pretty much for the long run and suffer through a few downfalls now and then. But I don't think I can call [where the market is headed right now]. I've pretty much been positive on stocks all the way through, and I think it's really worked out. Right after the financial crisis, people were so afraid of stocks; but of course, that was the most wonderful time to buy. Now, they've gone up a lot; but still, I don't really want to time it. But I do think you should hold stocks for the long run.
Benz: So, you should have an appropriately long time horizon in mind.
Ibbotson: Yes. Frankly, individuals are somewhat notorious for getting it wrong.
Benz: Advisors and institutions don't always get it right either!
Ibbotson: Anyway, there is a natural tendency to overreact, and I would suggest that you not do that in the stock market.
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Benz: Investors who have foreign-stock holdings have generally seen them underperformed over the past five years relative to U.S. Do you have a sense of foreign-stock valuations versus U.S.? A lot of the reason that foreign-stock funds have underperformed is the currency effect--that the dollar has appreciated and that has reduced the value of some of the foreign-stock funds.
Ibbotson: Actually, the dollar is a big factor. That's one thing I'm actually somewhat good at. I've never run currency funds, but I actually have made forecasts. And at these conferences, I have talked about how the dollar, at that time, was going to fall because of deficits and so forth. I've often talked about that and how the dollar, I thought, was definitely going to rise in this kind of environment. The euro has been so overpriced for such a long period, and now it's dropping, of course.
The yen was so overpriced, and the only way they could correct the yen from being so overpriced was to have deflation. And so that's particularly painful for an economy, and Abenomics in Japan has strongly brought in quantitative easing. That's the main one of their three heroes, I must say. And what it really impacts is the currencies, first of all, and the stock markets and bond markets. The problem with all of these quantitative-easing plans is they don't impact the labor markets as much as they impact the currency and the bond and stock markets.
Benz: So, it sounds like you think, though, that the dollar could continue to appreciate and that investors may see that phenomenon for a good while?
Ibbotson: I think the dollar will continue to appreciate, but I also think that these other markets, particularly Europe, are more attractive now because, first of all, the dollar has already appreciated quite a bit. I don't think it's over, but it has appreciated. And I think that the quantitative easing has a big impact on markets, and it's going to have less of an effect in Europe than it did in Japan or in the U.S. because Europe's such a fragmented market with all these different countries and so forth. They have to buy the bonds [from these various countries], and the quantitative-easing [program will have to accommodate] all of these different countries relative to the size of the countries and so forth, rather than relative to the misalignments and so forth. So, it's going to have a much smaller effect there, but still, it's positive. I would be positive on foreign equities, in general.
Benz: How about developing markets? Now, there is a category that investors of all types have tended to time really poorly, where they've tended to pile in after great performance. Do you have a thought on emerging markets and the potential for emerging markets going forward?
Ibbotson: I think emerging-markets economies are going to slow.
Benz: They are, right?
Ibbotson: Yes. The big benefactor is the drop of oil, which at least the [countries] that are not exporters of oil would benefit from; but in general, they are going to have a slowing growth rate. But the stock markets have seemed to be surprisingly detached from the actual growth of these economies, and I think that emerging-markets stocks have potential, too, definitely.
Benz: One last thing I want to touch on with you is fixed income. I was looking back on a previous interview three years ago; I asked you about your outlook for fixed income, and you forecast about a 2% return for fixed income. Over the past three years, that's exactly what the [Barclays U.S. Aggregate Bond Index] has done. Let's talk about, going forward, your outlook for fixed income. My guess is that you think it should be pretty muted.
Ibbotson: The yields are so low right now. Of course, they can drop like last year; in 2014, they dropped from something like 3% to 2% yields. And that [results in] a tremendous increase in returns. So, longer-term bonds did really well last year in the bond market, but now we're back at these really low yields. And despite the fact that we don't have much inflation, there's not much upside in a bond. So, I can't imagine that you're going to get much above 2%. And if those yields do start to rise, you're going to have some big drops in bond prices. So, I would not buy much in longer-term bonds, basically.
Benz: Longer term, no. But in terms of investors positioning their portfolios, they might hear this and say, "Maybe I should avoid bonds altogether." What's your view on that stance from a portfolio-construction standpoint?
Ibbotson: I don't think you can avoid bonds altogether. Bonds have all different maturities. Cash is effectively a bond; it's just a short-term bond. And so everything is a bond, and we don't want the portfolio to be all equities. You do need bonds; I just don't want to go too far out in the maturity-duration schedule, essentially because they're not really going to have great returns. But they are going to at least temper the returns of the stock market, generally. Sometimes, they behave the same; sometimes, they behave differently from the stock market. It's not a clear-cut how they behave; but if you go back to the financial crisis of 2008, having bonds in the portfolio was a great savior because at least the high-quality bonds did quite well in the financial crisis. So, you need some of those bonds just for diversification.
Benz: The last asset class I want to touch on is the "other" asset class. Are there any other categories that investors need in their portfolios, whether real estate, commodities, or precious metals? What should go in that other slot?
Ibbotson: Well, "need" isn't quite the [word], because just stocks and bonds and cash take care of the basics; but it's nice to have other asset classes that have different behavior--that don't act like the stock and bond markets. And a lot of them behave differently, all these categories: real estate, commodities, hedge funds. Especially something like our hedge fund at Zebra Capital, which is designed to be zero beta. It definitely behaves differently from stock and bond markets. It's nice to have funds that are different. So, yes, I encourage having some alternatives in a portfolio. Though, it may be difficult to actually put those alternatives in an individual portfolio.
Benz: And you would limit them as a portion of the total portfolio to what percentage?
Ibbotson: Well, I don't think I would name a percent because it has to do with how much access you have. For example, if you look at what actually people invest in, most individual investors' biggest investment, I would say, first of all, is in their human capital, which is sort of a different topic. The second-biggest investment is in their real estate, but it's usually their house or their one house, so you are not holding a diversified portfolio of real estate. So, it has to do with whether they can access that particular real estate. REITs are an easier-to-access kind of real estate, but they might be too popular and may not necessarily have great returns.
Benz: Valuations aren't so attractive there right now.
Ibbotson: Yes, they are not necessarily attractive.
Benz: Roger, thank you so much for being here to share your insights.
Ibbotson: Thank you.
