What would be the best portfolio in today’s market if 24/7 news cycles and portfolio statements did not imperil your reputation through short-term dips?
That “Desert Island Portfolio,” as John West of Research Affiliates calls it, would consist of today’s “most feared and loathed” areas of the market: emerging stocks and bonds.
Emerging-market stocks and bonds are poised to significantly outperform U.S. stocks and bonds over the coming years — based on current valuation criteria — but most investors will lack the nerve to buy them, or if they do buy them, to hold them.
So argues an analysis by West, a managing director of Rob Arnott’s Research Affilliates, based on the idea that advisors and managers of capital are constrained from optimizing returns by the fact that all professionals must report to someone.
West cites a variety of evidence that continuous performance measurement pressures investment professionals to manage short-term returns to avoid the risk of falling short of benchmarks and peer groups. After all, the client, after firing you, won’t get the benefit of the long-term investment gains, anyway.
Shiller P/E ratios on emerging stocks range from 10 to 15, implying subsequent 5-year nominal returns at a median of 13.6%.
That’s “almost a full 1,000 [basis points] compounded per annum for five years” over U.S. stocks, which at a Shiller P/E of 23.8, currently reside in the 90th percentile of their historic range and can expect median nominal returns of 4.2% per annum over the next five years based on historical averages. (Using more conservative assumptions for emerging-market stock performance, West posits a still healthy 500 basis-point advantage over U.S. stocks.)
The investment analyst then compares a typical 60/40 U.S. stock/bond blend (which he dubs the “Mainland” portfolio) with a “Desert Island” portfolio consisting of 20% emerging-market stocks; 30% emerging-market bonds; 30% high-yield bonds (esteemed for their above-average inflation protection); and 20% low-beta absolute return strategies (added to dampen portfolio volatility).