Curb investor sentiment

Francis Kinniry, a principal at Pennsylvania-based Vanguard Investment Strategy Group, doesn’t time markets.

And, he doesn’t believe in short-term domestic or global outlooks.

He’s exercised this belief during his 15 years at Vanguard and the 10 years before that he spent at a private money management firm.

“We’ve studied most of the tactical asset allocation programs that are out there, whether they be in mutual funds or in separate account managers, and the performance is very poor,” he says. “We find it foolish, if not irresponsible to give short-term forecasts.”

Instead, he and his research team of 30, which includes PhDs and CFAs, invest based on the allocation for clients, including institutional and retail investors, and financial advisors. The team’s philosophy is to control diversification and costs.

However, Kinniry, who was in Toronto on a chilly day in April, can discuss the longer term. The U.S. will continue going through a deleveraging cycle and interest rates and inflation will remain low, he says. But that’s not all.

Q. What else is important?

We have to check investor expectations. For the last 20 years they’ve been enjoying great returns from bonds. But we have to make them understand the forward-looking expectation for bond yields is probably half what it’s been. We’re not calling for a bond bubble but we do believe investors may be disappointed.

On the equity side, historically we’ve seen real returns of 5% to 6%. It wouldn’t surprise us over a normal cycle (five- to 10-years) that the stock market averages 7% to 9%, but with a lot of volatility.

Q. What’s your investment process?

We rarely give point estimates. The stock market return I just provided is one of those rare occasions. Instead, we talk more about the distribution of returns and relative risk premiums between asset classes, meaning how the interaction of those asset classes works.

Q. Why does this work?

It’s embedded in the historical framework of volatility and has been well tested through CFA research. All you can control are your costs, diversification and asset allocation. The case for indexing shows professional money managers have had a hard time in Canada, the U.S., Europe and Australia. If the professionals doing bottom up stock picking have a hard time getting an unmanaged index, then making forecasts should be treated with some strong concern.

Q. What are some common mistakes investors make?

They hear a good story and get caught up in it. For instance, we’ve seen a tremendous amount of inflow into emerging markets. There’s no doubt there’s growth there, but people have overpriced the story.

As a result, emerging markets as a whole are down 600 basis points year-to-date [as of April 2013] compared to developed markets. All of a sudden what was a glorious investment for 10 years has flipped in the last year and a half. Emerging markets are now concerning us as an overweight. We’re not calling for a bear market, but we do think returns will be more similar to developed markets.

Meanwhile, it’s hard to believe Japan’s market is up 45% in the last six months, especially with media reporting slow growth and poor demographics. In this case, the price-to-earnings ratio is the only predictive measure in forecasting returns. And even there, it’s only giving you a small prediction value. So with Japan I wouldn’t listen to what the media is saying to form expectations. Instead, look at companies’ price-to-earnings ratios.

Q. What currencies do you hedge against?

We hedge against most of the currencies on our fixed-income portfolios because people want exposure to the market.

On the equity side it differs. For instance, in Canada we have the Canadian [portfolio] hedged back to the Canadian dollar and we have an unhedged version, depending on investors’ objectives and goals. In the U.S., we don’t hedge because the market is so large (45% compared to Canada’s at 3%).

Q. Any advice for investors?

In the 1980s and 1990s, the stock market was returning 15% to 20%, and the bond market was eight to nine commodities with very high returns. But now that we’re in a low rate, low inflation environment, it means low returns. So investors have to pay attention to what they can control — costs.

Q. And what about for advisors?

In the U.S., Europe and Australia, we’ve seen costs come down for active funds and advice. But in Canada, it’s still very high.

Advisors in it for the long run have to recognize that in the current low rate environment, investors might have portfolios returning 4% to 6%. If they’re paying you 3%, that’s half their return and they’re taking all the risk —they aren’t going to do that much longer.

So advisors must recognize they need to lower costs if they still want to be in business in 10 years. The way to do that is by allowing investors to pay directly for fees. You’re going to see consolidation in the business from those who get it and those who don’t. There are already many emulating the U.S. or Australian models. Australia mandated fee transparency and costs have come down. If it’s happening globally, it’s just a matter of time before it happens here.