Showing papers by "Robert D. Arnott published in 2002"

What Risk Premium Is “Normal”?

Abstract: The goal of this article is an estimate of the objective forward-looking U.S. equity risk premium relative to bonds through history—specifically, since 1802. For correct evaluation, such a complex topic requires several careful steps: To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps. We demonstrate that the long-term forward-looking risk premium is nowhere near the level of the past; today, it may well be near zero, perhaps even negative.

What Risk Premium is 'Normal'?

Abstract: We are in an industry that thrives on the expedient of forecasting the future by extrapolating the past. As a consequence, investors have grown accustomed to the idea that stocks "normally" produce an 8% real return and a 5% risk premium over bonds, compounded annually over many decades. Why? Because long-term historical returns have been in this range, with impressive consistency. Because investors see these same long-term historical numbers, year after year, these expectations are now embedded into the collective psyche of the investment community. Both figures are unrealistic from current market levels. Few have acknowledged that an important part of the lofty real returns of the past has stemmed from rising valuation levels and from high dividend yields which have since diminished. As this article will demonstrate, the long-term forward-looking risk premium is nowhere near the 5% of the past; indeed, it may well be near-zero today, perhaps even negative. Credible studies, in the US and overseas, are now challenging this flawed conventional view, in well-researched studies by Claus and Thomas [2001] and Fama and French [2000, Working Paper], to name just two. Similarly, the long-term forward-looking real return from stocks is nowhere near history's 8%. Our argument will show that, barring unprecedented economic growth or unprecedented growth in earnings as a percentage of the economy, real stock returns will probably be roughly 2-4%, similar to bonds. Indeed, even this low real return figure assumes that current near-record valuation levels are "fair," and likely to remain this high in the years ahead. "Reversion to the mean" would push future real returns lower still. Furthermore, if we examine the historical record, neither the 8% real return nor the 5% risk premium for stocks relative to government bonds has ever been a realistic expectation (except from major market bottoms or at times of crisis, such as wartime). Should investors require an 8% real return, or should a 5% risk premium be necessary to induce an investor to bear stock market risk? These returns and risk premiums are so grand that investors should perhaps have bid them away a long time ago - indeed, they may have done so in the immense bull market of 1982-1999. Intuition suggests that investors should not require such outsize returns, and the historical evidence supports this view. This is a topic meriting careful exploration. After all, according to the Ibbotson data, investors earned 8% real returns over the past 75 years, and stocks have outpaced bonds by nearly 5% over the past 75 years. So, why shouldn't investors have expected these returns in the past and why shouldn't they continue to do so? Expressed in a slightly different way, we examine two questions. First, can we derive an objective estimate of what investors should have had good reasons to have expected in the past? And, why should we expect less in the future than we've earned in the past? The answers to both questions lie in the difference between the observed excess return and the prospective risk premium, two fundamentally different concepts that unfortunately carry the same label, "risk premium." If we distinguish between past excess returns and future expected risk premiums, it is not at all unreasonable that the future risk premiums should be different from past excess returns. This is a complex topic, requiring several careful steps to evaluate correctly. To gauge the risk premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps, in reverse order, to form the building blocks for the final goal: an estimate of the objective, forward-looking equity risk premium, relative to bonds, through history.

Rebalancing a Global Policy Benchmark

Abstract: The need to rebalance institutional assets to a policy benchmark is a simple fact of life While it may be possible for investors to allow portfolios to drift over a period of time, they will eventually have to address the misallocation this causes, as the mix becomes increasingly concentrated, overexposed to the riskier asset classes and underexposed to the more conservative asset classes Some investors may rebalance the asset mix by systematically directing new money into the underweight asset classes or by choosing the overweight asset classes as a source for withdrawals Others may choose to rebalance on a quarterly basis, before they are called upon to report to their investment committee However loosely the constraints on active moves away from policy benchmark are defined, the authors argue that the fact remains that a fund9s assets and liabilities must appropriately balance; drifting too far from the policy benchmark can prove disastrous when markets fail to deliver what one has been conditioned to expect

Risk Budgeting and Portable Alpha

Abstract: In the past decade, the institutional investing community has pursued two major advances in the management of risk. First, many institutional investors have come to realize that there need not be a direct link between their asset allocation decisions and their sources of “alpha” or risk-adjusted value-added above benchmark. This is known as “portable alpha” earning alpha in one market and “porting” it into another. Second, risk budgeting is seen as an important tool for the measurement, apportioning, and managing of risk. The two concepts are interrelated: although one can pursue either idea individually, they are best pursued in parallel.

Equity risk premium forum

Abstract: Biographies ROBERT D. ARNOTT is managing partner and CEO at First Quadrant, LP. Previously, he served as equity strategist at Salomon Brothers and as president and chief investment officer at TSA Capital Management. Mr. Arnott co-edited the first and second editions of Active Asset Allocation and Style Management and is the author of numerous articles. He has received four Graham and Dodd Awards of Excellence for articles published in the Financial Analysts Journal and is a member of the editorial boards of the Journal of Portfolio Management, Journal of Investing, and Journal of Wealth Management. Mr. Arnott holds degrees in economics, applied mathematics, and computer science from the University of California. PENG CHEN, CFA, is vice president and director of research at Ibbotson Associates. He conducts research projects on asset allocation, portfolio risk measurement, nontraditional assets, and global financial markets. His writings have appeared in various journals, including the Journal of Portfolio Management, Journal of Association of American Individual Investors, and Consumer Interest Annual. Mr. Chen holds a bachelor's degree in industrial management engineering from Harbin Institute of Technology and master's and doctorate degrees in consumer economics from Ohio State University. Cornell has served as an associate editor for a variety of scholarly and business journals and is the author of several books and numerous articles published in various finance journals. Professor Cornell holds an A.B. in physics, philosophy, and psychology, an M.S. in statistics, and a Ph.D. in financial economics from Stanford University. director of the Museum of Western Art and as a writer and producer of PBS documentaries. He is the author or co-author of numerous articles on finance and real estate and is co-editor or editorial board member for