FORTUNE – Rob Arnott is one of the few major investors who buys and sells almost any asset anywhere in the world. Not only does he manage Pimco’s $27 billion All Asset Fund (PASAX), but as chairman of Research Affiliates he has also devised strategies used to manage $100 billion. Arnott is the father of “fundamental indexing,” an approach that weights companies in an index by their size in the economy rather than their market capitalization. The latter approach, Arnott argues, causes index funds to skew toward hot, overpriced “winners.” Mutual funds and ETFs based on Arnott’s research are sold by Invesco PowerShares, Schwab, and Pimco.
These days Arnott sees a mediocre future for U.S. equities and bonds. Investors, he says, need a broad range of assets, and emerging-markets stocks and bonds have exceptional potential. His PowerShares FTSE RAFI Emerging Markets ETF (PXH) has posted annual returns of 26.3% since 2009, compared with 25% for the MSCI emerging-markets index. Here’s how Arnott is investing today:
Many on Wall Street say U.S. stocks are cheap based on price/earnings ratios. What’s your view?
U.S. stocks are actually pretty expensive today, and here’s why. Earnings regularly swing above or below trend by a wide margin. Wall Street is brilliant at taking peak earnings and predicting big future growth from those high levels. But history is replete with reversion to the long-term averages. When you have peak earnings, as companies do now, competition mounts and earnings falter.
Earnings as a percentage of GDP are the highest since 1929, and wages as a percentage of GDP are the lowest since 1937. Mean reversion takes it the other way, where wages rise and profits fall. Using Robert Shiller’s cyclically adjusted price/earnings ratio (see chart), which uses 10-year average earnings rather than peak earnings, today’s P/E ratio is 22 or 23. That’s pretty high.
So what kind of return should investors expect in U.S. equities?
Over the next 10 years, a 5% nominal return is what investors can expect. That compares with a 2% return from 10-year Treasuries. But 5% from stocks is way below what people want to earn on their riskier investments. Unfortunately, that’s the reality right now. To get higher returns, it’s necessary to look outside the mainstream of U.S. stocks and bonds.
Where can bond investors find higher returns without substantial risk?
Ten-year Treasuries are a poor investment at a 2% yield, especially with the Fed and Congress trying to create perfect conditions for renewed inflation. Emerging-markets bonds are far better. They provide 3% to 4% more yield, and their debt coverage ratios, measured as GDP to total debt, are beautiful. Those ratios are terrible for the U.S. and European nations. The G-5, the world’s five largest economies, have 40% of world GDP and 70% of world sovereign debt. Emerging markets collectively have 40% of world GDP and 10% of world sovereign debt. The coming decade will demolish the illusion that developed-world sovereign debt is safe and that emerging-market debt is reckless and speculative. A country like Chile is now a lot safer than Italy or France.
How should people go about investing in those bonds?
I like the idea of broad baskets of emerging-market countries. They’re safer than cherry-picking individual countries. The yield on a basket of emerging-markets sovereign debt would be 6.3% for seven- to eight-year maturities, a spread of 4.5% over Treasuries.
Do you see opportunities in U.S. corporate bonds now?
U.S. high yield is just fine. It’s offering six points over comparable Treasuries, or around 8%. That’s high by historical standards. The norm is a spread over Treasuries of four points. So you get a rich starting yield. It’s also a beautiful stealth hedge against moderate inflation. When inflation rises, Treasury yields could rise two or three points, but high-yield rates could actually fall to 7% or so, restoring the normal four-point spread. That would give investors a capital gain in addition to the rich yield.
Looking around the globe, where do you see the best buys in equities?
I’d have below-average allocation to equities in general, and starkly below average in the U.S. The best allocation is around 20% to 30% in equities, with less than half of that in the U.S. Europe and Japan are getting to be mildly interesting because of the recent decline in prices.
Best is emerging markets. Their stocks are trading at a 20% to 30% discount to U.S. equities. Everyone sees emerging markets as the growth engine for the world economy. If so, why are they trading at a big discount to the parts of the world that are not the growth engine?
As for U.S. stocks, the small allocation should be at the value end of the spectrum. Apple (AAPL) is a great example of how growth investing sometimes works, and a great example of the pitfalls of growth investing because there aren’t a lot of Apples. With growth stocks, the expectations for future earnings are extremely high, and if they don’t materialize, investors get hit hard. So don’t try to find the next Apple.
This story is from the June 11, 2012 issue of Fortune.
