As our investment universe has expanded up and down the market cap spectrum, and to encircle the globe, we have found tracking more indices quite helpful. We thought our clients and prospective investors could benefit from our view of the world at year-end both to characterize the recent past and to look forward. Broadly speaking, we track domestic stocks across the cap ranges, international issues, and even bonds. The returns below represent five calendar years, along with an annualized return for the entire period.
In 2012, international stocks topped domestic stocks (where small-caps edged large-caps), with bonds a distant laggard. This essentially flips the order from 2011.
From our perspective, the story of the last half-decade continues to be investors' love affair with bonds and extreme distrust of equities—despite the handsome returns stocks have generated of late. Although December results are not yet available, it is clear that 2012 will be the fifth straight year of outflows from U.S. stock funds— totaling approximately $300 billion in total over the full period. Meanwhile, investors have plowed more than triple that amount—over $1 trillion—into municipal and taxable bond funds. A superficial look at performance suggests why bonds have been so popular: their five-year total return is much higher than the various equity groups, and they have gained between +4% and +8% in each of the last five calendar years.
Meanwhile, stock returns are lower—plus international as well as domestic small-caps have lost money in two of the past five years. We think investors are unfortunately limiting their analysis to a surface-level view and are thus missing what is more important. After all, since the carnage of 2008, stocks have crushed bonds. On an annualized basis, large-caps have gained +14.58% and small-caps have increased +15.81%—more than double bonds at +6.12%. The total return gap is even greater: the Russell 2000 Index has essentially tripled the Barclays U.S. Aggregate Bond benchmark. In large part, we think investors are fleeing a crash that is receding in the rear-view mirror: the losses of 2008. As is true of driving, it is important in investing to spend most of your time looking out the windshield rather than at the road already traveled. From that perspective the so-called "flight to safety" looks reckless more than cautious to us. Domestic bonds have rarely if ever had worse prospects, broadly speaking.
The 10-year Treasury yield is just +1.8%—about one-fourth the income such bonds have provided long-term and among the lowest on record. Meanwhile, the comparable earnings yield of the S&P 500 Index and Russell 2000 Index are +6.7% and +6.1%, respectively, which are within the normal ranges but a bit better than average long term. We would much rather own an asset with an attractive yield in-line with historical norms than an investment much worse than the typical range—and we think overdue for a painful reversion to the mean.
As we enter into 2013, the equity world around the globe is generally the way we like it to be. Specifically, although the business fundamentals look solid, the animal spirits, headlines, and valuations suggest a significant amount of fear. More importantly, the most-cited sources of anxiety are only tangentially linked to an active, focused portfolio of stocks—the half-solved Fiscal Cliff issue, the European debt crisis, and even the New Normal. Such macroeconomic matters only mildly hurt strong companies' long-term fundamentals but can really hit stock valuations—creating ample opportunities for contrarian investors, in our view. Although many asset managers insist on rank-ordering their favorite asset classes, we can report that all of our portfolio managers, from micro-cap to all-cap, from domestic stocks to international fare, are finding plenty of attractive opportunities. Even though equities have already had three very good absolute return years in the last four, we continue to think 2013 will be a normal or even better-than-normal year for most of our asset classes based on prospective growth rates and overall valuations. As always, we strive to outperform with our highly-active, always-patient, contrarian investing style.
The opinions expressed are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. Analyses and predictions are based on assumptions that may or may not occur, and different assumptions could result in materially different results.
Bonds are fixed income securities in that at the time of the purchase of a bond, the amount of income and the timing of the payments are known. Risks of bonds include credit risk and interest rate risk, both of which may affect a bond's investment value by resulting in lower bond prices or an eventual decrease in income. Treasury bonds are issued by the government of the United States. Payment of principal and interest is guaranteed by the full faith and credit of the U.S. government, and interest earned is exempt from state and local taxes.
MSCI EAFE® Index is an unmanaged, market weighted index of companies in developed markets, excluding the U.S. and Canada. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indices or financial products. This report is not approved or produced by MSCI. The Russell Midcap® Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Index represents approximately 27% of the total market capitalization of the Russell 1000 companies. The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 8% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The S&P 500® Index is the most widely accepted barometer of the market. It includes 500 blue chip, large cap stocks, which together represent about 75% of the total U.S. equities market. The Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS.
Investors should consider carefully the investment objectives, risks, and charges and expenses before investing. For a current prospectus or summary prospectus which contains this and other information about the funds offered by Ariel Investment Trust, call us at 800-292-7435 or visit our web site, arielinvestments.com. Please read the prospectus or summary prospectus carefully before investing. Distributed by Ariel Distributors, LLC, a wholly-owned subsidiary of Ariel Investments, LLC.