April 21, 2009
“Most investors expect their stock holdings to outpace their bonds over any reasonably long span of time,” writes Rob Arnott in a soon-to-be-published paper, Bonds: Why Bother? Not so, Arnott concludes — there are “many misconceptions in these core views of modern finance.”
We disagree and find little support for the notion that Treasury bonds will outpace stocks, at least over the next 40 years. To the contrary, our review of the data suggests exactly the opposite.
In a second aspect of his paper, Arnott argues that fundamental weighting can be successfully applied to bond indexing. We contend that fixed income investors face problems more important than the construction of index funds.
His paper, which will appear later this month in the Journal of Indexes, also contains an interesting review of equity versus bond performance over the last 200 years and of the diversification value of bonds.
Bonds for long run?
Arnott’s doubts equity superiority in large part because he found that over the 40-year period ending in February, Treasury bonds did in fact outperform stocks. Arnott shared his data with us, and we confirmed that the 40-year return on stocks was 8.57%, versus 8.62% for bonds, for this period. Stocks similarly underperformed bonds (8.70% versus 8.79%) for the period that ended in March 2009.
But, starting in January 1926, these were the only two 40-year spans where the anomaly existed. For all other 40-year spans, stocks beat bonds.
Arnott compared returns on the S&P 500 (including dividends) to returns on a constant 20-year maturity Treasury bond, and his results are shown in the graph below. He used monthly return data, obtained from Ibbotson, and calculated the geometric mean over successive 40-year intervals, annualizing the results.
Equity returns have been surprisingly stable, averaging a healthy 10.95% over this period and staying mostly within a band of approximately 9% to 13%.
The disappearance of the equity risk premium is due almost entirely to the remarkable increase in bond returns. Until 1980, bonds returned a stodgy 2%-4%, but since then bond performance has marched steadily upwards, returning a remarkable 8.79% over the 40-year period ending in March.
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