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The World According to 'The Bear'


As Robert Arnott steps out of a taxi en route to a CNBC interview at the New York Stock Exchange, two young Italian tourists stop him on the street. "Do you know where The Bull is?" asks one of the young men clutching a map. The bull in question is Charging Bull, a 7,000-pound, 16-foot-long bronze sculpture by Italian artist Arturo Di Modica that stands in Bowling Green Park.

Arnott, an investment guru who lives in California, isn't familiar with the twisty streets of Lower Manhattan, but one of his colleagues points the tourists in the right direction. I Little do the Italians know that they've just met The Bear, a.k.a. Rob Arnott, chairman of investment advisory firm Research Affiliates.

Big and burly, with a gray-flecked beard and a bit of a belly after loading up on pastries during a trip to Europe, Arnott certainly looks the part. His bearish outlook informs the way he manages $35 billion for clients such as pension giant CalPERS. Included in that $35 billion is $15.2 billion he runs in the Pimco All Asset Fund (PKO) for Pacific Investment Management (Pimco). Index strategies he has created are used in products offered by a variety of investment companies, including some Charles Schwab (SCHW) mutual funds. The strategies are also the basis for a slew of exchange-traded funds (ETFs) listed in the U.S., France, Sweden, and elsewhere.

Stocks are likely to move lower in the next six months and will be in hibernation for years, predicts Arnott. "For the long-term investor, stocks will offer single-digit returns over the next 10 to 20 years, though individual years could be far better or worse," he says. Among Arnott's worries: Congress getting too protectionist or doing a massive bailout of the housing market. Even after such musings, though, Arnott says: "I don't perceive myself as wildly bearish, but compared to rest of world I am." He does see some bright spots. "There are always places to invest," he says. He likes U.S. Treasury Inflation-Protected Securities (TIPS) and local currency emerging markets debt.

Arnott, 53, made his name as a pioneer in the wonky-sounding field of tactical asset allocation. He advocates actively shifting assets among categories—stocks, bonds, real estate, commodities—to take advantage of pricing anomalies or strong market sectors. He's also known for his bold, big-think forecasts. "His talent is his insight," says Nobel prize-winning economist Harry Markowitz, who is an adviser to Research Affiliates. Arnott's views are closely followed by leading financial advisers such as Louis Stanasolovich, a Pittsburgh wealth manager. "A lot of people are focused on what is happening this minute. Rob steps back and says: 'Here's the big picture,'" says Stanasolovich, CEO of Legend Financial Advisors.

Stanasolovich has invested more than $20 million of his clients' money in the Pimco All Asset Fund. In that fund, Arnott mixes quantitative screens with his own insights to rebalance the portfolio among investments such as stocks, bonds, TIPS, commodities, emerging-market debt, and real estate. The fund, which invests only in other Pimco portfolios, is up 6.01% for the past year, 4.8 percentage points ahead of the Dow Jones Moderate Portfolio Index, according to fund tracker Morningstar. The fund's five-year annualized return, however, is 6.77% through June 9, below the 10.69% return for its benchmark. All Assets's top bets include inflation-related strategies (30%), alternative bond strategies (26%), short-term strategies (14%), and equities and convertible bonds (10%).

MATH GEEK AT THE BEACH

At the beginning of May, Arnott and about 15 colleagues moved some 50 miles from Pasadena, Calif., up to Newport Beach to be closer to Pimco, Arnott's biggest client. But the unofficial reason for the change of location is that Arnott fell in love with the beach when he was studying economics, applied mathematics, and computer science as a student at University of California at Santa Barbara in the 1970s.

Now he and his wife, Marina, are living in a beachfront property—but he rents it. His skepticism about equities, it turns out, is paired with a weak forecast for real estate. His says it makes more sense to rent a $5 million house for $8,000 a month than to be saddled with a huge mortgage and high property taxes: "That's the situation in coastal [Orange County]."

His big-picture view on real estate is that plunging home prices will continue to fuel a consumer-spending slump. That's because the cash consumers tapped from home-equity loans amounted to 5% of gross domestic product, he says. Arnott figures that roughly half of the $600 billion in home-equity withdrawals was used to buy consumer goods in 2005.

From his new stomping grounds, Arnott continues to beat the drum for a subject he's passionate about: fundamental indexing. It's a way of weighting indexes on metrics such as sales, cash flow, and dividends rather than by market capitalization. Although several people claim to be pioneers in this area, Arnott puts his stamp on the theory in a new book, The Fundamental Index: A Better Way to Invest (Wiley; $29.95), which he co-authored with colleagues. "If I didn't write it," he says, "someone else would."

Arnott says there is a basic problem with traditional indexing: Companies are weighted by market capitalization, which leads to an overweighting of overvalued companies and an underweighting of undervalued ones. Fundamental indexers say focusing on metrics such as sales makes it easier to identify the most undervalued companies. "The idea behind the traditional index fund is a very powerful one," says investor and author Peter Bernstein, an adviser to Arnott. "To take issue with it in this way takes Rob Arnott's tenacity and thinking."

Indeed, Arnott's tweaking of the tenets of passive investing raises the ire of indexing stalwarts such as Vanguard Group founder Jack Bogle, whom Arnott considers an investment hero. "My problem is that the basic thesis of fundamental indexing is definitely not proven," says Bogle, who's skeptical of backtesting data that show such indexes outperforming the Standard & Poor's 500-stock index by two percentage points annually for the past 46 years.

Bogle also notes that the PowerShares FTSE RAFI U.S. 1000 ETF, which uses Arnott's strategy and tracks the performance of the largest U.S. equities based on book value, cash flow, sales, and dividends, is down 13.4% for the past 12 months, while the Vanguard 500 Index Fund is down 7.93%. "He's gone down almost twice as much as the market in the last 12 months. That's pretty remarkable," says Bogle. "It's especially remarkable since he assured the world that his theory also gave better downside protection."

"Of course it has underperformed," Arnott counters. The cap-weighted index tilts toward growth companies, while fundamental indexes favor value companies, he explains.

The controversy doesn't end there. Among fundamental indexers, there's squabbling over who gets credit for the idea as well as the optimal way to construct a fundamental index. Arnott says he stays out of the fray to focus on getting more institutions to buy his index products. Just $30 billion of $5 trillion in indexed assets is in fundamental indexing strategies.

Arnott takes a measured approach to his hobbies, too. In January he set a goal of riding at least two of his 20 vintage motorcycles every month. (He's a little behind on his goal.) Some of his prized bikes include a Morbidelli built by Enzo Ferrari's engineering team and a 1949 Vincent Black Lightning that set an Australian Land Speed Record of 154 mph in 1949. His worst fear: that fellow cycle enthusiast and talk show host Jay Leno will find out about a bike he's interested in and outbid him.

Arnott also travels the globe chasing solar eclipses. "A total solar eclipse is the most remarkable—and beautiful—spectacle that the skies can offer us," he says. His goal is to spend an hour of his life under eclipses—no easy feat considering some last for 30 seconds. So far he has viewed nine, including one from Eastern Antarctica. He expects to cross the half-hour mark on Aug. 1, in Central China.

Bear markets, like eclipses, can be fleeting, but Arnott foresees a down market with staying power. "We've only seen the first leg," he says.

Links

Not So Fast

Fans of traditional indexing are answering the challenge. A May 17 New York Times column by Joe Nocera focused on Harvard University professor André Perold's critical review of fundamental indexing, pitting Perold and his supporters against the likes of Rob Arnott of Research Affiliates and Jeremy Siegel, the Wharton School economist who consults for Arnott's chief rival, WisdomTree Investments. The column concludes that fundamental index funds shouldn't be viewed as replacements for market-cap-weighted index funds.


Steve Ballmer, Power Forward
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