All Asset All Access

All Asset All Access, December 2019

Research Affiliates discusses why they believe value investing is still alive and well and explains how changes to the display of expense ratios seek to enhance clarity for investors.

In this issue, Rob Arnott, founder and chairman of Research Affiliates, explains why Research Affiliates believes the reported “death” of value investing has been greatly exaggerated, while John Cavalieri, asset allocation strategist for PIMCO, discusses how changes in the presentation of expense ratios for the All Asset funds seek to improve transparency for investors. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: Many pundits and investors have recently suggested that value investing is dead. Given the value-oriented approach of the All Asset strategies, how concerned are you?

Arnott: Over the last 12 years, value investing has underperformed growth investing by nearly 30% cumulatively through the end of October 2019.1 Are we alarmed by these outcomes? Hardly. Are we concerned by how investors will likely react to these results? Yes. 

People in our industry generally shun whatever hasn’t worked lately. Tacitly, this means that we expect past winners to be future winners. We’ve written about this tendency extensively. In fact, we published a paper in November looking at our RAFI (Research Affiliates Fundamental Index) strategies relative to both value and cap-weighted markets.2 All Asset and All Asset All Authority share this value orientation with the RAFI and RAE (Research Affiliates Equity) strategies, along with our confidence in long-horizon mean reversion.

It takes discipline and a tolerance for “maverick risk” – winning (or losing) unconventionally – to shrug off the temptation to chase recent performance. Value investing can be challenging for a very simple reason: It necessitates buying whatever is most out of favor. When we buy whatever is unloved, and it doesn’t work out immediately, investors can understandably lose patience. Human nature conditions us to avoid whatever has caused pain and losses – which is why the capital markets are the only major segment of the global macroeconomy in which customers hate a bargain! And, of course, whatever is out of favor always has a market narrative or “story” that speaks to why things should only get worse.

Extrapolating from past returns,3 relying on stories to confirm unfounded beliefs, shunning whatever has been painful, and reacting by following the herd are among the well-known causes of many investors’ travails. Keynes explained the problem 80 years ago, in words that ring as true today as ever:

“… it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

Sadly, history seems to fixate on the last sentence, while largely ignoring its foundations in the preceding text.

History is rife with examples of prognosticators, pundits, or media outlets questioning the long-term viability of asset classes or investing styles. Business Week’s cover story in 1979 heralded “The Death of Equities,” which was ironically followed by a multi-decade bull run for U.S. stocks. The Economist concluded in March 1999 that cheap oil “is likely to remain so”; over the next eight years, Brent crude was on a steady march to price levels well in excess of $100/barrel. Later that same year, amid the “dot com” euphoria, the Wall Street Journal concluded that Warren Buffet “may be losing his magic touch” (he was having his first lagging year after beating the S&P 500 for 18 consecutive years!). Of course, over the next decade Berkshire Hathaway stock outpaced the S&P 500 by roughly 7% per annum!

When we study these examples and others, the performance leading up to “death statements” tends to fall within their normal range of return outcomes, and subsequent rebounds have tended to be fast and strong. Abandoning one’s core investment philosophy can potentially be very costly.

Fast-forward to today. Many pundits and investors (and even academics) claim that value investing is dead and offer various explanations to support this view, many of which seem plausible. Some suggest that structural changes in the capital markets and macroeconomy now allow growth stocks to be permanently more profitable than their value counterparts. Many point to the extraordinarily low interest rates over the past 12 years, ostensibly providing a tremendous net present value for long-horizon growth stocks.4

Many say that as the U.S. has moved from a manufacturing to a service economy, conventional measures of value such as the price-to-book ratio inadequately classify value stocks, because they exclude the value of intangible investments.5 Others suggest that the value trade is crowded, distorting the prices and lowering the expected returns of value stocks. Finally, Research Affiliates and others note that the lousy performance across value strategies in recent years may simply result from value becoming cheaper and cheaper relative to growth; the very process of becoming cheaper would create bad performance.

We are working on another paper coming out soon that tests many of these ideas. In our view, none of them comes close to the power of the premise that value has underperformed simply by getting cheaper and cheaper. Value has lagged growth by 2.7% per year since 2007, but it has done so by getting 4% cheaper per annum relative to growth! Imagine if the valuation spread between growth and value had remained steady; by our calculations, value would have been outperforming growth by over 1% per year.6 Imagine if the trend reverses, and value reverts toward past relative valuation norms at that same 6% annual pace; by our calculations, value would theoretically outperform growth by 9% per year!

Although value has been out of favor for over 12 years – since the All Asset strategies have been live – the strategies have outperformed their primary benchmarks over the full span since launch. As of 30 September, the strategies had delivered a net of fees since-inception return of 6.66% for All Asset Fund and 4.89% for All Asset All Authority Fund, representing excess returns of 2.70% for All Asset Fund and 0.78% for All Asset All Authority Fund versus the Bloomberg Barclays U.S. TIPS 1-10 year Index and Bloomberg Barclays U.S. TIPS Index,7 respectively. We believe that even if we’re behind the very markets that we exist to diversify away from, we have at least generated an attractive yield while we wait for the eventual turn of conditions that favor value-oriented, diversifying strategies.

Buying low and selling high is painful. It requires us to act objectively on future expectations and not to simply chase what’s worked in the past. It also requires us to act contrary to instincts shaped by millions of years of evolution. This may be why you – like us – have chosen an investment process that embeds “buy low and sell high” discipline through an unwavering rebalancing engine that drives long-term potential value-add – a hallmark of the All Asset strategies.

This figure shows the yields and fund performance of PIMCO’s All Asset Funds as detailed in tables, as of 31 October 2019. Fund performance current to the most recent month end is available at 

For the most recent quarter-end performance data for the All Asset and All Asset All Authority funds, please click on the links below:

Q: Have there been changes to the way the expense ratios of the All Asset funds are displayed in the funds’ marketing materials?

Cavalieri: Yes, in accordance with recent regulatory developments, we have made a key addition to the way we disclose the funds’ expense ratios in fund marketing materials (but not prospectuses) that we believe increases transparency for investors.

Specifically, FINRA recently provided guidance that allows firms in the industry – including investment managers (such as PIMCO) and other firms, such as Morningstar – to display, subject to certain conditions, an additional expense ratio that excludes certain expenses that are not fees paid to the investment manager. This new figure is called the “adjusted expense ratio,” and we believe it provides much-needed clarity to investors because it better isolates the fees payable to the fund manager.

So what, specifically, is the adjusted expense ratio, and how does it differ from the existing expense ratios?

First, let’s consider a fund’s gross expense ratio (GER). The GER reflects all fees and expenses used to run and manage the fund, expressed as a percentage of the fund’s average net assets.  This includes fees paid to the manager as well as other operating expenses of the fund, which are not fees payable to the fund manager (we’ll explain these momentarily). It is also shown before applying any applicable fee waivers; hence the term “gross.” 

The GER is required to be displayed for all funds registered under the Investment Company Act of 1940 (e.g., mutual funds, exchange-traded funds (ETFs), and closed-end funds), whereas the following two expense ratios are supplementary.

Second is the net expense ratio (NER). The NER is simply the GER reduced by any applicable contractual fee waivers. Both All Asset Fund and All Asset All Authority Fund currently have contractual fee waivers in place (and have since their inceptions) through 31 July 2020,8 which directly benefit shareholders. As a result, PIMCO always shows the NER in addition to the GER for the All Asset funds. 

Lastly, and introduced in fund marketing materials most recently, is the adjusted expense ratio (AER). The AER is a fund’s GER (or NER if fee waivers are applicable), further reduced by the fund’s interest expense, which is a specific type of investment-related operating expense of the fund (explained below). We believe the AER is a relevant expense ratio for investors who want to focus on the expense ratio of a mutual fund or ETF net of fee waivers and net of these investment-related expenses, in order to better highlight the fees payable to the manager. So, as with the NER, PIMCO now also shows the AER for both All Asset Fund and All Asset All Authority Fund across our fund materials and websites (see fund fact sheets below).

This chart shows the start date, asset size and expense ratios of PIMCO’s All Asset Fund, as detailed in tables, as of 30 September 2019 This chart shows the start date, asset size and expense ratios of PIMCO’s All Asset All Authority Fund, as detailed in tables, as of 30 September 2019 

Why might it be relevant to exclude interest expense from a fund’s expense ratio?  As mentioned, interest expense is an investment-related expense, one that is incurred as part of a broader trading strategy designed to increase returns of the fund, net of the interest expense. Essentially, interest expense is the cost of borrowing cash (from certain transactions including reverse repurchase agreements, forward-settling transactions, and direct borrowing from external facilities), which is typically used to acquire securities with an expected total return greater than the borrowing cost. As such, these “two-legged” financing strategies are designed to increase net returns to the fund. PIMCO has used these “two-legged” financing strategies across our client accounts and funds for decades in seeking to enhance returns for shareholders in a risk-prudent fashion (as described in PIMCO’s February 2019 publication, “The Role of Structural Alpha Strategies in Active Bond Management”).

While some might think that this borrowing cost would be netted within the fund’s performance, accounting rules dictate that this type of interest expense be reported in the fund’s GER and NER and, in turn, in the expense ratios that appear in the fee table of a fund’s prospectus. This has the effect of highlighting the “cost” leg of the trade without providing a means to similarly highlight the associated potential “return” component of the overall trade. As a result, some investors observe an elevated GER or NER (attributable to interest expense) and presume either that the manager’s fees are increasing (not so in the case of the All Asset Fund or All Asset All Authority Fund) or that their net return must be going down due to elevated fund expenses (not necessarily).

PIMCO is not alone in our view that an expense ratio that excludes interest expense is relevant and may provide clarity to investors. While there are many examples we could choose from, we believe the view of Morningstar is relevant here, as quoted from its August 2018 publication, “A Fee Methodology Update Makes Some Funds' Fees (Appear to) Swell”:

Philosophically, Morningstar analysts view short interest and dividend expenses as trading costs that are intrinsic to a fund's strategy. For the same reason, Morningstar excludes brokerage costs from the annual report and prospectus net expense ratios of all funds (this practice will continue).

The use of the reported interest and dividend cost in the prospectus also doesn't allow for apples-to-apples comparisons across funds. Depending on the leveraging techniques employed by the fund, the fund may or may not be required to report interest or dividend expense. Funds that employ shorting strategies or reverse-repo transactions are required to report interest expense in their filings, whereas funds that employ futures, swaps, TBAs, and forwards are not required to report the cost associated with those instruments as interest expense.

Interest and dividend costs in general can vary widely over time and across funds depending on the economic environment, the tools involved, and the magnitude to which they're being used. Because of these differences, Morningstar analysts will continue to back out all interest and dividends on borrowed securities in order to compare a consistent value across funds when determining Price Pillar ratings and overall Analyst Ratings.

PIMCO remains committed to providing clarity to our clients regarding not only our investment views and portfolio strategies, but also their associated costs and benefits. As such, we will continue to show the AER, in addition to the NER and GER, in the All Asset funds’ marketing materials going forward, as well as for any other PIMCO funds that incur reportable interest expense in pursuit of higher net returns for investors.

Further reading

Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:

  • How partnerships with academic thought leaders inform methodology and positioning and a look at the All Asset strategies’ beta-adjusted performance versus peers (November 2019)
  • Why Research Affiliates’ contrarian philosophy may add value over the long term and how the growing likelihood of a global economic slowdown is affecting positioning (October 2019)
  • Asset class bubbles and “anti-bubbles,” factors driving yields, and the benchmark change for All Asset All Authority (September 2019)
  • How the All Asset strategies have performed during inflation surprises and potential benefits of these strategies for defined contribution plans (August 2019)
  • A look at some often overlooked potential benefits of the All Asset strategies and insight into Research Affiliates’ approach to trading (July 2019)

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 As measured by the HML (High Minus Low) factor in the Fama French three-factor model, which accounts for the spread in returns between value stocks and growth stocks.
2 Interested readers can learn more in “Standing Alone Against the Crowd: Abandon Value? Now?!” published on the RAFI Indices website.
3 We’re working on a paper that looks at “nowcasting”: presenting a cogent thesis for whatever has already happened, masquerading as a forecast. It sounds intelligent and is less likely to damage one’s reputation if it turns out wrong. Indeed, memory will trick us into thinking the forecast was made before the history that created the nowcast! As with perhaps 80% of the market and economic forecasts that we see today, the “death of value” thesis fits beautifully into this simple definition.
4 If so, then why aren’t European and Japanese stocks trading at nosebleed valuation levels, given their negative interest rates? Perhaps the low rates reflect anemic growth expectations, not just a low discount rate?
5 As an aside, we believe it’s unwise to select a single measure such as book-to-market value – especially when there are strong reasons to believe that the book value accounting measures have been distorted.
6 We calculate underlying components that comprise value-to-growth’s return differential (measured by the Fama French HML factor noted in footnote 1). One component is the return due to change in aggregate valuation, which is also referred to as the revaluation alpha component. We find that the average revaluation alpha is -4.2% per annum, since 2007. Another component is the structural alpha, which is comprised of both profitability and migration. It represents value’s excess return over growth without the revaluation component. Since 2007, this component was 1.3%. So, if the valuation spread between growth and value is zero (or steady), value would have outperformed growth by 1.3% per annum.
7 Prior to 13 September 2019, the primary benchmark of the All Asset All Authority strategy was the S&P 500 Index. For more information behind the rationale for this change, please see the September 2019 issue of All Asset All Access.
8 PIMCO has contractually agreed, through 31 July  2020, to reduce its advisory fee to the extent that the Underlying PIMCO Fund Expenses attributable to advisory and supervisory and administrative fees exceed 0.64% (for the All Asset Fund) or 0.69% (for the All Asset All Authority Fund) of the total assets invested in Underlying PIMCO Funds. This waiver will automatically renew for one-year terms unless PIMCO provides written notice to the Trust at least 30 days prior to the end of the then-current term.  For complete information, please see the funds’ prospectus.
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Robert Arnott

Founder and Chairman, Research Affiliates

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