TORONTO - Keith P. Ambachtsheer has a modest proposal for traditional core equity portfolios: dump them.
Core portfolios, typically indexed or enhanced index funds, play a logical role in a world where equities provide a risk premium over the "riskless" rate available from long inflation-linked bonds.
But in a world where the equity risk premium has shrunk to zero - as Mr. Ambachtsheer, president of K.P.A. Advisory Services Ltd., a Toronto-based pension consultant, believes - the composition of the core portfolio comes into question.
The lack of an equity risk premium "questions whether broad-market portfolios still are the appropriate proxies for what you might call core investing," Mr. Ambachtsheer said in an interview. Instead, he proposes that institutional investors create a core portfolio consisting of a small group of stocks expected to beat a predetermined hurdle rate over the long term.
Instead of focusing on tracking error against a published benchmark, investors would need to step back and figure out what role the core equity portfolio plays within the total fund, he wrote in a recent advisory letter sent to his clients.
Efficient-markets theory requires investors be paid a premium for investing in stocks. A draft paper by Eugene F. Fama and Kenneth R. French, two prominent efficient-markets theorists, projects the equity risk premium will fall sharply from the 8.3% level achieved during the second half of the 20th century.
Their main conclusion: High stock returns from 1950-1999 were "due to a decline in discount rates that produces large unexpected capital gains" that is unlikely to be repeated. Dividend yield and earnings growth models predict far lower risk premiums, 0.69% and 2.12%, respectively, well below the 3.4% average for 1950-1999, they wrote.
While Messrs. Fama and French did not predict a zero equity risk premium, Mr. Ambachtsheer and a small group of investment professionals, including Robert D. Arnott, managing partner of First Quadrant Corp., Pasadena, Calif., and Ronald J. Ryan, president of Ryan Labs Inc., New York, think the equity risk premium might be flat or worse (Pensions & Investments, Nov. 13).
The result is a conflict between the real return that should be provided according to efficient-markets theory and what the stock market can provide on a sustainable basis, he explained.
Efficient-markets theory suggests investors earn an equity risk premium of, say, 2% to 4% on top of the current yield on Treasury inflation-protected securities, or TIPS, of 3.8%, Mr. Ambachtsheer wrote. That would suggest a real return projection between 5.8% and 7.8%.
But the fundamentally sustainable real return is far lower. The projected total return is the 1.5% current dividend yield plus real long-term dividend/earnings per share growth of between, say, 2% and 3%, he wrote. The upshot is the sustainable rate is between 3.5% and 4.5% - nearly the same as the riskless investment rate.
That means institutional investors must stop concentrating on tracking error as the key issue in creating a core equity portfolio, Mr. Ambachtsheer wrote. Instead, they must replace the broad stock market with a hand-picked portfolio of stocks held for the long term and provide an equity risk premium, and a set level of risk, he added. Thus, the portfolio would have a target return of 7%, assuming a 4% risk-free rate and a 3% real return.
He used the example of a hypothetical fully funded plan with 100% inflation-sensitive liabilities and a trustee-imposed 13% limit on "surplus at risk."
Mr. Ambachtsheer calculates the core equity portfolio must offer an expected equity risk premium of at least 2.2%. Added to the 3.8% TIPS return, "that implies a minimum required equity market real return of 6%." And he claims that, using an optimizer, such a portfolio could be constructed to carry less risk than a broad-market indexed portfolio.
"By reclaiming passive management from approaches which blindly follow commercial versions of `market portfolios,"' this hypothetical fund "appears to have stumbled on the Holy Grail: more expected return at less expected risk than that embodied in conventional passive management strategies."
But some observers find this prospect too good to be true.
James Creighton, managing director and global head of indexing at Deutsche Asset Management, New York, said he's "not sure it makes it easier to pick a portfolio that outperforms the risk-free rate. But I think he's absolutely right (that) the optimum portfolio and the core portfolio absolutely would change, certainly for an institutional investor."
Peter L. Bernstein, president of the eponymous consulting firm and consulting editor to the Journal of Portfolio Management, said if investors could create a core equity portfolio of selected stocks that would outperform the index, "you'd be doing it already."
Mr. Ambachtsheer's solution "is in a sense whistling in the graveyard because I don't believe you can do that without taking on different kinds of risks," Mr. Bernstein said. Instead, pension funds may be better off using tactical asset allocation to be positioned to take advantage of the next big shift in the market.