Robert Arnott, founder and chairman of Research Affiliates, discusses how differences between the All Asset and All Asset All Authority strategies contribute to their relative performance in different environments. Jim Masturzo, head of asset allocation for Research Affiliates, discusses critical components of the portfolio allocation and trading infrastructure underlying the All Asset strategies. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: How should investors think about the difference between All Asset and All Asset All Authority, including which factors have driven one to outperform the other in various environments?
Arnott: We launched the All Asset suite of strategies over 15 years ago to complement investors’ portfolios by serving as their diversifying source of real returns. Relative to the All Asset strategy, All Authority is designed to provide a more differentiated, more focused exposure to “Third Pillar” assets (including real assets, emerging markets and high yield bonds) than its sister strategy, All Asset, and it can have a lower correlation to mainstream stocks. To help achieve this, All Authority has two additional tools at its disposal. First, it can use modest leverage – a maximum of 1.5x on invested capital – to deploy more assets in diversifying markets where (in our view) the return potential exceeds the cost of leverage. Second, All Authority can invest in an underlying U.S. short equity strategy, which allows us to target an even lower overall U.S. equity beta. The short position, of course, uses up some of the allowable leverage; we have never used all of the leverage merely to ramp up our long Third Pillar holdings.
By design, All Authority is intended to be far less correlated to mainstream stocks than its sister fund. From 30 October 2003 through 28 February 2019, the strategies’ correlations to the S&P 500 were 54% for All Authority and 70% for All Asset. To put these numbers in context, over the same timeframe a balanced 60/40 portfolio (represented by 60% S&P 500 and 40% Bloomberg Barclays U.S. Aggregate Bond Index) had a correlation with the S&P 500 of 98% –99%, and the average correlation for funds in the Morningstar Tactical Allocation and World Allocation categories was 91%.1 Such strategies tend to be more exposed to equity market returns (and risks) than the All Asset strategies, and indeed more than many investors may realize.
Over the same span, All Authority’s beta to the S&P 500 was 0.36x, lower than All Asset’s 0.46x. Hypothetically speaking, imagine if we had used leverage to boost All Asset’s positions by 20%. Volatility would have been about 20% higher, and beta would have been about 0.55x. Imagine if we then took a short position of 20% on the S&P 500. About half of All Asset’s incremental risk would have disappeared, and the beta would have fallen back to about 0.35x. That’s almost exactly what the long-term volatility and beta in All Authority have looked like.
Accordingly, in a U.S. equity bull market, All Authority may lag the All Asset strategy. But in turbulent markets or U.S. equity bear markets, we expect All Authority to outperform its sister fund, and to do so over a full market cycle (i.e., peak-to-peak or trough-to-trough). If All Authority’s short-term performance has been disappointing in recent years, we believe the reasons are simple and twofold. First, since 2013, Third Pillar markets have offered low average returns; an equal-weighted blend of six major Third Pillar assets2 returned just 2.64% annualized for the five years ended 31 March 2019. Second, in our view, we’ve been in a prolonged low-volatility bull market that has seen U.S. equities meaningfully outperform most other asset classes as the S&P 500 valuation (i.e., cyclically adjusted price/earnings or CAPE ratio) has risen to top-decile levels. If the coming decade brings turbulence and a bear market or two, we would expect to see All Authority perform well on both an absolute basis and relative to its sister strategy.
Historical results have aligned with these expectations for outperformance during acute U.S. equity market sell-offs. Using daily return data, we can take a look at the downside mitigation the All Asset strategies have delivered during these periods (see Figure 1). For a moment, consider all periods when U.S. stocks’ consecutive daily peak-to-trough loss exceeded 15% since the launch of All Authority. The four episodes include one big bear market, the global financial crisis (9 October 2007 – 9 March 2009), and three serious market corrections, including the European sovereign debt crisis in 2010 (23 April – 2 July), and in 2011 (29 April – 8 August), and the most recent sell-off in 2018 (20 September – 24 December).
For the most recent quarter-end performance data for the All Asset and All Asset All Authority funds, please click on the links below:
While past is not prologue, the ability of the All Asset strategies to mitigate damage during these market sell-offs is wholly consonant with their mission and design, and with our management of the portfolios. Did both strategies meaningfully outperform the S&P 500 in each of these four market declines? Yes: The average drop in the S&P 500 was 26.92%, compared with 7.79% for All Asset and just 3.66% for All Authority. In all four cases, All Authority abated losses to a greater degree than All Asset, even delivering a gain in 2010. If we include smaller market declines (of 10% or more) during the current 10-year bull market (as shown in Figure 1), while All Asset sharply reduced investors’ losses, All Authority outperformed All Asset during each of the corrections.
Such market conditions have occurred infrequently over the life of our strategies. No wonder: These strategies have seen two large bull markets and one large bear market. Over the past 10 years, we have seen the longest equity bull market – and one of the strongest – in the history of U.S. capital markets. From the launch of the All Authority strategy through 28 February 2019, market declines of 15% or more occurred less than one-seventh of the time (on 557 of 3,999 days).
Of course, the All Authority strategy is not for everyone. It is designed for investors willing to tolerate high “maverick risk” – the risk, to paraphrase Keynes, of failing conventionally while seeking to succeed unconventionally.3 It is for those who are willing to weather the short-term discomfort inherent to a more differentiated Third Pillar contrarian positioning for a more potentially powerful hedge in those inevitable moments when diversification is most needed.
Q: Can you discuss the portfolio infrastructure underlying the management of the All Asset strategies?
Masturzo: Since the birth of the All Asset strategies in 2002, the underlying asset allocation infrastructure – which we refer to as “Calypso,” after explorer Jacques Cousteau’s research vessel – has evolved to a multi-capacity system that allows us to both effectively execute the strategies as they are today while also testing research ideas to potentially enhance performance in the future.
When discussing the systems behind the All Asset strategies, there is a tendency to focus on “the model,” or the component that ultimately suggests weights for each holding in the portfolios. However, this is only one, albeit an important, piece of the much larger set of systems necessary to effectively manage the All Asset strategies. And “the model” is somewhat of a misnomer, as it is actually refers to a series of models working in concert to construct the portfolio weights.
We chose the name Calypso as a reminder that the All Asset strategies’ success requires a balance of continual improvement through forward-looking research coupled with real-time traditional portfolio management decisions and activities. Look forward, but be mindful not to run aground! While Calypso includes a number of components, its primary elements, which we describe in more detail below, can broadly be identified as 1) a portfolio engine, 2) a trade calculator, and 3) an analytics and reporting engine.
The portfolio engine, which is analogous to “the model” referred to previously, is a set of modules that take in fundamental, market and economic data and transform that data into signals on asset classes and ultimately to portfolio weights. The process starts with the generation of risk and return forecasts for the set of asset classes used to model the underlying PIMCO funds in the All Asset universe. These forecasts start with long-term estimates, tactically adjusted based on indicators of the current state of the business cycle across countries and regions. These risk and return estimates are mapped to the investible universe of PIMCO funds through a set of structural exposures and a forward-looking estimate of the excess return we feel the PIMCO funds may achieve. We then run these inputs through a mean-variance optimizer to help determine what we believe are optimal portfolio weights, while also accounting for the fact that the expected returns are not point estimates, but distributions of potential return scenarios.
Although a model portfolio is produced daily, the All Asset strategies do not trade directly to these daily models. The reason is that the model can respond to small changes in the market with minor changes to the portfolio weights, of a few basis points. Trading to these moves would incur unnecessary costs as well as excess turnover, resulting in potentially unprofitable trades. Instead, the portfolio management team monitors the model for indications of meaningful trades, at which point the target trade portfolio is updated. This is where the second component, the automated trade calculator, comes in: Its role is to move the live portfolio holdings to the target portfolio in an efficient way, which is to say, in a way that aims to minimize the effect on market prices. Because the holding period of the All Asset strategies is on the order of two to three years, trading does not need to be immediate; we can move into or out of a position over days or in some cases weeks in an effort to minimize costs to investors. The trade calculator also contains rules to handle client cash flows into or out of the funds, using these flows where possible to close gaps between the live and target portfolios.
A common misconception about the management of the All Asset strategies is that “the model” is a “set it and forget it” process. The reality is that managing the All Asset strategies entails daily monitoring of both historical (ex post) trends, as well as future-looking (ex ante) characteristics. The third component of Calypso is our custom analytics and reporting suite that allows us to measure and manage both types of data, to act as a secondary check on the actions of the model as well as to identify situations that may be outside of the model’s purview. In these situations we may make subjective adjustments to the portfolio weights determined by the model.
We believe added transparency into the process is essential and expands the information set needed for investors to make allocation decisions. To provide a window into our process and a better understanding of our approach, Research Affiliates also offers both current and potential All Asset investors interactive tools to help understand the long-term capital market expectations and to quantify the probability of a portfolio achieving a range of real returns over a 10-year horizon, using transparent and well-documented methodologies for estimating asset class and portfolio return forecasts.
Just as the All Asset strategies are not static, Calypso was not designed to be a static system. Instead, the components of the Calypso system were designed to evolve organically with the needs of the All Asset strategies. Over time, new insights will be identified, tested, and either rejected or accepted for inclusion into the management of the funds – tasks that would be infinitely more difficult without a robust infrastructure to aid in the process.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:
- Assessing investment risk in terms of the likelihood of meeting long-term wealth accumulation goals (March 2019)
- The potential impact of a bear market in U.S. stocks on emerging markets (February 2019)
- Research Affiliates’ outlook and asset allocation views for 2019 (January 2019)
- Market impact of the U.S. midterm elections and what differentiates All Asset’s positioning versus peers (December 2018)
- Outlook for achieving All Asset’s long-term real return benchmark and its approach to assessing country risk (November 2018)
- Three key ways to “bucket” the All Asset strategies and a recap of year-to-date returns (October 2018)
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. 1 Source: Morningstar as of 28 February 2019. The Morningstar category group for All Asset and All Asset All Authority is Tactical Allocation. We include the combined percentage for the Tactical Allocation and World Allocation categories because the All Asset strategies invest across multiple asset classes.
2 Consists of an equally weighted blend of U.S. high yield (Barclays U.S. Corporate High Yield Index), long U.S. TIPS (Barclays U.S. Treasury Inflation Notes: 10+ Year Index), EM local bonds (JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged)), EM equities (MSCI EM Index), REITs (Dow Jones U.S. Select REIT Total Return Index), and diversified commodities (DJ-UBS Commodity TR Index).
3 We believe the “cost” of a more differentiated Third Pillar source of real returns is not in the form of higher volatility, but rather greater “maverick risk.” Since the launch of All Authority, both strategies’ absolute volatility levels have been comparable, registering at 8.9% for All Authority and 8.7% for All Asset. But tracking error versus the S&P 500 is tangibly higher for All Authority, at 11.3%, versus 9.6% for All Asset.