Asset classes are often declared irretrievably broken after poor recent performance, implying they are unable to provide reasonable forward-looking returns. These proclamations are often nowcasts, a common and dangerous financial practice of explaining what’s already happened as if it’s a forecast of the future.
We survey (admittedly) anecdotal examples of so-called broken asset classes. In most cases, their performance fell within their historical range of expected returns. Further, following this declaration they often produced sizeable excess returns.
We offer practical tips for advisor conversations with clients about underperforming asset classes and their role in a portfolio.
Pundits, prognosticators, and even investment boards often make misleading declarations that an asset class is broken, that its prospects for earning investors a reasonable future return are very dim. These proclamations can lead to investors’ abandoning these assets to chase recent winners. Advisors are uniquely positioned to educate their clients about historical asset-class returns and provide context for recent, perhaps disappointing, performance. In this way advisors can prepare their clients for substantial variations in an asset’s returns. A prepared client is a confident one. And confidence begets the tenacity to hold assets over the long term, raising the likelihood of a successful investment experience via diversification, rebalancing, and long-term compounding. And isn’t that what financial advice is all about?
Warnings of the long-term impaired viability of asset classes have spooked investors through history. One of the most notorious was Business Week’s cover story “The Death of Equities” published in 1979. US stocks are not alone however; other “broken” asset classes abound. By the late 1990s, REITs were dismissed as “losing [the] power to diversify a portfolio” (Henderson, 1998), and a 1999 article in The Economist concluded cheap oil “is likely to remain so.” Fast-forward 20 years to the present. Headlines teem with sentiments such as “Does Investing in Emerging Markets Still Make Sense?” (Wheatley, 2019) and “Is Value Investing Dead? It Might Be and Here’s What Killed It” (Li, 2019).1
History is littered with examples of reputable pundits, media outlets, and prognosticators cautioning investors about broken asset classes, typically at the heels of sagging absolute returns or poor results relative to mainstream markets. Similar warnings also occur during investment board meetings. In his consulting days, John recalls, back in February 2000, a board meeting of an $800 million pension fund. Recent market movements (namely, growth stock outperformance) had pushed the fund’s asset allocation out of compliance with its investment policy statement, requiring a large rebalance out of growth stocks into core bonds and small-cap value.
The resistance to the mandated rebalance was unsurprisingly (for those who may have lived through this period) stiff, with one board member stating that “small-cap value is a dead asset class.” Indeed, it appeared the board preferred to eliminate small-cap value rather than top it up. Fortunately, the investment policy statement compelled the rebalance to go through. To this day, John will tell you it was one of his most rewarding experiences in investment management given the absolute dollar value created for the fund’s members as growth stocks plunged, small value stocks surged, and bonds steadily advanced during the bear market that eventually culminated in late 2002.
When headlines lead to clients’ questioning their investment strategy, we suggest advisors use comprehensive historical return ranges to most effectively gauge recent results on an absolute basis and relative to a mainstream asset such as US equities (i.e., the S&P 500 Index). We will review how seemingly impaired assets are rarely permanently defunct. In most cases, the performance of a broken asset class is well within its range of historical returns, and outperformance often follows a period of underperformance as mean reversion takes hold. Clients benefit from a greater understanding of the potential long-term upside in recently beaten-down assets.