Rob starts with showing us what type of returns one can expect over the next ten years from the typical US market fund, and then shows how to remove some of the drags of negative alpha which hurt those returns. This is a very important piece and one I think you will want to read more than once.

Rob is the founder and head of Research Affiliates. He has published scores of articles in various financial journals, won four Graham and Dodd Scrolls for his writing, travels and is the keynote speaker at too many conferences to mention and is recognized as one of the top financial minds in the world. He wrote a chapter in my book, Just One Thing.

He is also the creator of the Fundamental Index (patent pending) which is exploding onto the market. When I first wrote about it three (maybe four? Time flies.) years ago, I said that fundamental indexes would be the fastest new investing concept to grow from zero to $100 billion in history. Today there is almost $20 billion invested in various kinds of fundamental indexes all over the world, and the number is growing rapidly, as some of the largest pension and institutional investors in the world are adopting the concept to replace their traditional index investing. At the end of this letter, I mention a few places where you can find funds and information...

Now, let's turn it over to Rob and John.

Guest Column by Rob Arnott and John West, of Research Affiliates, LLC

Past is Not Prologue, and Hope Is Not a Strategy

The capital markets of the last quarter century have been incredibly generous to us. Since mid-1982, the S&P 500 index has advanced at a solid 13.9% annual clip, while 10-year Treasury bonds have posted annualized returns of 9.8%. With annual inflation averaging just over 3%, this means that investors have seen their real wealth double every seven years in stocks and every 11 years in bonds. But, past is not prologue.

Would a bond investor, looking at 25-year returns of 10% and current long bond yields of 5% be foolish enough to expect the next 25 years to deliver 10%? Of course not. They'd recognize that yields started in 1982 at 14% and had plunged to 5% over the next 25 years, earning hefty capital gains on top of a yield averaging 7% over this span. With current yields of 5%, they'd expect 5%.

So, if stocks were yielding 6% in 1982, and are now yielding 1.8%, should we expect to repeat the 13.9% of the past quarter-century? Of course not. On average, 5% a year came from capital gains attributable to multiple expansion - over and above what growing earnings and dividends contributed. Take that away, and we're at 9%. After all, that's what we'd have earned if dividend yields still matched the average yield of the quarter century. But, even that's too aggressive. Dividend yields are 2% lower than their average during this span and 4% lower than the starting yield of 1982. Take 2-4% away, and we should expect 5-7% from our stocks in the years ahead.

Over the past century, dividends have provided over two-thirds of the real returns earned in US stocks. Today, they hover well under 2%, while nominal bond yields are in the 5% range. Simple arithmetic points to 5% returns for bonds and 5-7% for stocks - if their respective yields don't rise in the years ahead! Rising yields and shrinking P/E ratios would mean capital losses which would reduce returns below these levels, much as falling yields and rising multiples fueled the wonderful returns of the past 25 years.

A lot of investors, even professional institutional investors, aided and abetted by their consultants and actuaries, don't like this arithmetic. So, they dismiss it, preferring to forecast the future by extrapolating the past. This is perhaps the worst possible way to construct expectations. It led actuaries to assign very low return assumptions (6% was typical) for pension funds in 1982, at a time when 14% could be locked in with government bonds, and when stocks were producing that same 6% in dividend yield alone, without even allowing for any growth, capital appreciation or inflation, all of which could, and did, add mightily atop that 6% yield. Why such low expectations? Because returns from 1965 to 1982 had been wretched.

Extrapolating the past similarly led to 10% and higher return assumptions at the peak of the bubble in 2000, at a time when bond yields were 6% and stocks were offering a scant 1% yield. Why such high expectations in a world of low yields? Because returns from 1982 to 1999 had been truly extraordinary. In 2000, I wrote a short paper entitled "Death of the Risk Premium," with Ron Ryan, which was received with widespread derision, but ultimately proved correct: plain old 10-year government bonds have produced higher returns than stocks since then, by a cumulative margin of over 30%, despite the durable bull market since 2002. And, even if we include the bubble of 1998-2000, stocks have beaten bonds by well under 1% per year over the past decade.

Today, no matter how fuzzy the arithmetic, it is difficult to justify long-term returns from conventional stock and bond balanced portfolios exceeding 5-7%. We can decry the math and its conclusions, but investors can only dismiss it outright at their peril. Since most plan on 8-10% returns (if not more!), the vast majority of long-term investors are confronted with a large shortfall between likely portfolio returns and what they hope to achieve.

Worse, if inflation drains off 2-3% a year - it would be awfully dangerous to count on a more benign long-term inflation outcome than this - and if taxes take away one-third of our 5-7% total return, we're left with pretty close to zero real return, net of taxes and inflation. Yikes.

Many, with spending plans that require 8-9% returns, hope such seemingly-bleak expectations prove off the mark. But hope is not a strategy. Rationally-inclined investors are grudgingly beginning to accept this likely reality. They recognize that it's far more sensible to take an alternative view: 5-7% returns aren't really all that bad, and so perhaps we should hope for more, aspire for more, develop strategies aimed at achieving more, but accept 5-7% as the base case scenario.

Eliminating Negative Alpha

Noting the gap between expected and required returns, many investors increasingly turn to "alpha" (value added from investor skill) as the elixir to cure their long term ailment. Meander through just about any industry publication and it is impossible to avoid the cascade of references on all things alpha - the quest for alpha, bids to increase alpha, alpha overlays, currency alpha, loosening constraints for alpha and the list goes on. It is almost as if manager skill is an assured and harvestable commodity. The very word "alpha" triggers feel-good pheromones in investors, as reliably as chocolate truffles or love. Few people bother to discuss the fact that alpha is a zero-sum game, with an average alpha of zero - less the costs associated with the quest for alpha. This means that most alpha is negative!

In investing, what is comfortable is rarely profitable. If the crowd is hell-bent on unearthing positive alpha, our own contrarian inclination points us in a different direction - very few of today's market participants are focusing as aggressively on eliminating negative alpha. Seeking, identifying and eliminating negative alpha is as profitable as seeking, identifying and employing sources of positive alpha.

We define negative alpha as the slippage investors unnecessarily incur in the ongoing management of their portfolios. A fancier term would be implementation shortfall. Eliminating all these various mistakes is not only profitable, it's vastly easier than competing with the crowd of alpha chasers.

Four major sources of negative alpha will be covered in today's discussion. No doubt, there are countless more that deserve additional consideration. Certainly, cost is an obvious example: all other things equal, the lower fee alternative will outperform; but, I think that is fairly self-evident. These four require a little more discussion as avoiding them requires considerable more effort than simply lining up expense ratios. They are:

1. Equity Concentration
2. Ignoring Rebalancing Opportunities
3. Chasing Winners
4. Cap Weighting in Stocks

Equity Concentration. Holding equities for the long run is a nearly universal mantra in our industry but there are many markets that appear to offer a "risk premium," ranging from commodities to emerging markets bonds, from real estate to timberland. Reliance on significant equity allocations, while ignoring these other markets, limits our ability to reduce portfolio risk through diversification. One of the best kept secrets in investing is the miniscule diversification achieved in the classic 60/40 traditional balanced portfolio. Due to their significantly higher volatility, sizable equity declines overwhelm bonds in this supposedly "balanced" construct. For this reason, the 60/40 mix has very nearly a 99% correlation with the S&P 500! If we use other "risky" markets selectively, opportunistically when they're offering premium yields, and on a scale large enough to matter, we can earn equity-like returns at far lower risk.

Not many recall the current decade as an easy time to make solid profits. Even the bull market from late-2002 until mid-2007 barely recovered the 2000-02 equity market losses for most investors. But as Figure 1 illustrates, for those who were not invested in an equity-dominated portfolio, especially those willing to stray outside of both mainstream stocks and bonds, many asset classes have delivered lofty returns. Indeed, most people would be surprised to learn that the average return of this list of markets was essentially the same: 9.3% per year in the first six years and 8.7% in the more recent six years! ...