Rob Arnott on RAFI’s Growth, and How to Address U.S. Debt

"We've got to change course on our spending," he said, and "accept the fact that our GDP is lower than it seems," since he said the deficit already accounts for 11% of GDP. Since GDP actually tracks spending, Arnott said spending 11% on debt is tantamount to a family that believes it's "economy" is in good shape because its spending is financed by using credit cards. "It's a dangerous morass," Arnott warned, to think that increasing the cost of servicing debt can somehow be offset by much higher economic growth. 

Not surprisingly for a company called "Research Affiliates," whose primary business, he says, is "licensing our ideas," Arnott said he had been doing a fair amount of research on "the three Ds—debt, deficits and demographics." Arnott steered away from blaming one or the other political party for profligate spending—"It's bipartisan: the party of big government and the party of bigger government." While he wouldn't predict which of the two parties would blink first, he was confident that "the side that won't blink is S&P and Moody's."

How should portfolios be adjusted, then, in light of a possible downgrade and higher inflation? Bonds may be fine now, he said, but Arnott is less sanguine about fixed income over the longer term. Stocks, he warned, are little better, since they are at a level that suggests we're at "an economic peak, not a trough." Inflation-linked bonds such as TIPS would be more attractive, as would high-yield bonds, which he considers "stealth hedges." Advisors have the tools investment-vehicle-wise, he argues, but the problem is that most advisors still have "90% of their portfolios in stocks and bonds," which is not where you want to be, he counseled, in a reflationary environment.

He thinks it will be an "interesting decade ahead," but worries that the only way to get the country's fiscal house in order to fix Social Security and Mediacre is by raising the age of eligibility, cutting back on benefits, and instituting means testing. That will need to happen partly because of the increases in life expectancy, where someone retiring at age 65 may well get Social Security checks for many decades to come. He believes it's untenable to expect the children, grandchildren and great-grandchildren to pay for those long-living retirees.

Getting back to Research Affiliates' impressive growth, Arnott acknowledged that there were vocal critics early on who have become "increasingly quiet," as fundamental indexing "gains traction all over the world." The traction is shown by $8 billion invested in the RAFI approach in Japan, $5 billion in Australia, $4 billion in Scandinavia and $6 billion in the rest of Europe (all numbers as of June 30, 2011). That traction and those assets attracted were helped, he said, by the early adopters of the RAFI approach—public funds, such as CalPERS, which has $6 billion in the approach, and retail—which turns on its head the normal adoption of newish investing strategies by institutions first.

Those constituencies, he said, we're already highly invested in traditional cap-weighted index funds, "so they knew its drawbacks." In addition, he said both financial advisors and RIAs "are increasingly interested" in the RAFI approach. Beyond the intellectual embrace of the fundamental indexing "intuitive" approach, the performance helps with adoption as well. Backtesting the strategy shows that a fundamental index approach adds about 2% performance over that of a cap-weighted portfolio of S&P 500 equities. Put another way, the outperformance is 2% to 4% in developed markets, Arnott reports, and over 4% in inefficient markets.