Rob Arnott, founding chairman and head of Research Affiliates, assesses actively managed strategies versus passive investment vehicles, and Shane Shepherd, head of research, discusses global economic growth prospects and their impact on positioning. As always, their insights are in the context of PIMCO All Asset and All Asset All Authority funds.
Q: Over the last few years, we’ve observed a significant rotation out of actively managed funds and into passive investment vehicles. In light of this rotation, how do you view the cost/benefit tradeoff of the All Asset funds’ allocating to actively managed PIMCO funds versus applying your investment process only to passive vehicles?
Arnott: It’s a truism that active managers can only win if a “loser” is on the other side of their trades. That loser can be another active manager, or it can be assets flowing into passive strategies, with holdings dictated by the published rules of the (typically) market cap-weighted index they follow. This can lead to a stark “membership effect,” differentiating stocks that are members of the indexes from nonmembers. While the financial media have been awash with reports of the migration from active to passive strategies, the data (shared below) paint a different picture, one that is far more supportive of the prevalence and value proposition of active management. Moreover, when we consider not just median manager results but rather the results of a specific, industry-leading manager – in this case, PIMCO – we can make an even stronger case. Within the All Asset funds, we invest in an array of PIMCO mutual funds, each of which is actively managed within its established guidelines. We believe PIMCO’s long-term results – having delivered value added across multiple asset classes, spanning decades – are evidence that active management can be well worth the effort, and specific to All Asset, have enhanced the returns to our investors, net of fees and expenses.
Since the beginning of the current decade, there’s been a notable rotation out of actively managed strategies and into passive and quasi-passive investment vehicles: Conventional active managers now represent only about one-third of the assets under management (AUM) for what we call “First Pillar” (mainstream stock market) mutual funds, with index funds and exchange-traded funds (ETFs – of all kinds) now making up the remaining two-thirds of the total (see Figure 1). The rising popularity of passive and ETF investing leads many to believe that a) passive exposure is preferred across all asset classes and b) passive investing is now synonymous with wise investing. Not in our opinion!
Contrary to what passive prognosticators might have you believe, within “Second Pillar” (mainstream bond market) and “Third Pillar” (diversifying markets – real assets, emerging markets and high yield bonds) funds, active management still dominates, representing two-thirds of the assets within their representative Morningstar categories. And why would we expect otherwise? If you’re a bond investor, you’re a lender. If you’re a bond indexer, you’re lending strictly in proportion to the debt appetite of the borrower. But ask: Why, on earth, would it make sense to do that? In commodities, currencies, real estate, emerging markets, and so forth, there are a host of reasons to expect less efficient markets. Something as simple as forward pricing (whether futures are selling at a premium or a discount to spot) in commodities is surprisingly predictive of future commodities price behavior. Currencies are heavily managed by governments, often acting with no evident profit motive. And the list of potential inefficiencies goes on.
Consider also the percentage of actively managed funds within each Morningstar category that have outperformed the median passive alternative over the past five years (see Figure 2). Within the First Pillar, an average of 38% of active managers have beat the passive alternative, but within Second and Third Pillar asset classes, a respective 73% and 58% of active managers have outperformed, on average. From this “rearview mirror” vantage point, we believe it’s clear active management has been dominant in Second and Third Pillar markets.
With some active managers the historical outperformance can be significant. Of the nearly 60 underlying PIMCO Funds we model for potential investing within the All Asset suite, 43 have a five-year track record. Of those 43 funds, 38 have delivered performance above the median passive alternative in their respective Morningstar category over those five-year spans, net of all fees, trading and implementation costs (we’re looking at institutional share classes). And this rate for PIMCO’s Funds remained high when we break it down across the three investment pillars. Within First Pillar equity categories, 91% (10 out of 11 Funds) of the PIMCO Funds in which the All Asset suite invests have outperformed the median passive alternative, net of costs. Within the Second and Third Pillar categories, PIMCO’s rates are 100% (12 out of 12 Funds) and 80% (16 out of 20 Funds), respectively. (Past performance is not a guarantee or a reliable indicator of future results.)
While these rates for fund families are certainly noteworthy, the magnitude of the excess returns also matters to All Asset investors (see table below).
For the most recent quarter-end performance data for each fund, please click on the links below:
We also disagree with the assumption that passive investing is inherently wise. Paying five to 20 basis points for performance at or a bit below the benchmark is a false bargain, in our opinion, when compared with paying reasonable fees for potential value added, net of fees and expenses. Consider: Within passive equity indices, is it wise to link the weight of a stock in your portfolio to its price, thereby always overrelying on whatever is overvalued and underinvesting in whatever is undervalued? The original defining aim of “smart beta” – and the source of alpha for these strategies – was to break the link between the price of a stock and its weight in the portfolio, so that investors are no longer assuredly overweight the overvalued and underweight the undervalued. With passive bond indices, is it wise to link the size of our bond investments to the total amount of issuance, thus buying more bonds from the most debt-addicted borrowers? Within passive commodity indices, is it wise to buy futures contracts at the point on the curve where the cost to roll is highest, and to roll those futures contracts on the same few days as all other indexers?
An important contributor to sustained excess returns for actively managed strategies, in many cases, is simply avoiding the structural shortcomings of passive investing – shortcomings that are only accentuated as more money flows into passive vehicles.
How might such shortcomings be overcome?
Within equity markets, we begin with our core conviction that the largest and most persistent investment opportunity is long-horizon mean reversion. Equity prices vary around fair value. When the market makes an error in pricing a stock, it eventually recognizes the error and corrects it. We wrote a paper in 2015 showing that we can potentially beat the market by using five-, 10- and even 20-year-old capitalization weights (!) because we’re no longer tying the weight to today’s error in the price of the stock. By systematically contra-trading price movements, buying what is feared and unloved and selling what has provided great comfort, investors can potentially harvest the returns from mean reversion. The systematic active PIMCO RAE equity strategies are designed to do exactly that, with some additional bells and whistles.
Within bond markets, structural considerations may provide active investors with a persistent advantage. As PIMCO’s Jim Moore pointed out in a recent piece, “Bonds are Different,” some investors (such as central banks) don’t have a profit motive; this, along with the flaws of issuance weighting, creates an immediate potential advantage for active over passive investing. Expertise within a large issuance market and the ability to negotiate better terms for large over-the-counter transactions are additional advantages of active bond management.
Both the historical track record and the structural advantage of the actively managed PIMCO and PIMCO RAE strategies continue to reinforce our belief that the management partnership between PIMCO and Research Affiliates remains the best value proposition for All Asset investors. In our view, PIMCO offers an industry-leading investment platform that covers the breadth and depth of global liquid asset classes and strategies. When compared with “low cost” passive alternatives, which often provide index returns minus fees and implementation costs, we see little room for debate.
Q: What is Research Affiliates’ outlook for economic growth across regions, and how does that influence positioning within the All Asset funds?
Shepherd: In developing return expectations for the asset classes we consider in the All Asset funds, our investment process has always centered on what we call the “building blocks” approach – quantifying the yield, growth and valuation change components for each asset class. A critical exercise that underlies our building blocks approach is our modeling of country-level GDP growth, which we do for 25 developed and emerging countries. GDP growth rates affect each building block of return and therefore play an important role in influencing the asset allocation decisions within the All Asset funds.
Let’s begin with our forecasts for real GDP growth and cash rates over the next decade (see Figure 3). We estimate GDP will grow three times faster in EM than in the U.S., with dramatically higher expected real cash rates for the former.
To estimate GDP growth for each country, we model the growth of GDP’s three key components: capital, labor and productivity. We also factor in the impact of workforce demographics. Why? Faster population growth provides a higher labor force growth rate, and a younger workforce (relative to an older one) is more likely to acquire skills that will enhance future productivity. Not surprisingly, these demographic trends signal a continuation of slow GDP growth in developed markets1 and meaningful divergence among emerging markets, with many offering potential for significantly higher GDP growth than developed markets.
How do our projected GDP growth rates feed into our forecasts for future interest rates? We model equilibrium interest rates using trend GDP growth and a time preference factor, which reflects a desire for savings in the economy.2 Faster-growing economies produce more goods and services for each dollar borrowed, delivering higher potential cash rate returns to investors. The time-preference factor raises interest rates where there is a relatively low supply of funds available for investment.3
Given that expected starting yields drive our long-term return forecasts, it’s no wonder EM currencies, with a 1.8% expected real cash rate, make up a tactically elevated position in the All Asset strategies! But it bears mentioning that the impact of real cash rates extends beyond currencies and into other asset classes. For instance, what informs our long-term real return prospects for EM bonds? Their currency exposure and a duration risk premium. So, we find EM bonds attractive largely because of their high cash rate. As for equities, we turn to dividend yield, real earnings growth,4 and expected valuation changes. Faster GDP growth tends to deliver higher real interest rates, which serve as the base return upon which the equity premium sits.
But aren’t U.S. interest rates beginning to normalize? Didn’t the Federal Reserve strongly hint at a normalization policy? Yes, and that is indeed reflected in our models. In the most likely scenario, we project the U.S. current real cash rate of −1.8% to rise to about zero over the next several years, with nominal short-term interest rates just about equaling inflation. In the long run, interest rates are set by economic conditions – not by central bankers. (Instead, central bankers generally aim to keep prevailing rates in line with estimates of the equilibrium interest rate, while managing short-term rates to smooth out business cycle fluctuations.)
Over the coming decade, we believe that aging demographics, declining labor force participation and a stiff debt overhang will continue to characterize the economic conditions of the developed world. These trends would, in turn, likely suppress GDP growth, equilibrium interest rates and return estimates. Given this outlook, we believe it’s prudent to diversify into economies with far more promising growth and interest rates. This is what we strive to do in the All Asset strategies.
The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the sub-advisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics: