Q: You’re sometimes described as “permabears.” Are you permabears?

Arnott: Not at all. If we think something is expensive, priced to offer lousy long-term forward-looking returns, we don’t want to own it. U.S. stocks were pretty fully priced from 2005–2008 and again from 2013–2016 (and, before managing the All Asset funds, I had the same view from 1998–2000). Investing elsewhere makes us seem like permabears, but we’re actually bullish on whatever we see as cheap. The cheap/expensive trade-off is never in absolute terms. Just because we avoid buying something doesn’t always mean we’re outright bearish; it can also mean we’re more bullish on other opportunities where we think compensation for taking risk is higher. In today’s New Neutral environment in which real interest rates remain depressed and many assets trade expensive versus historical norms, this relative trade-off becomes even more important.

Many of you are aware of the asset allocation application that we launched a couple of years ago on the Research Affiliates website. In a recent update, we introduced a portfolio analysis tool that allows investors to insert their own portfolio’s allocations to a broad opportunity set of global asset classes. Using Research Affiliates’ long-term forecasts for return, volatility and correlation – and assuming exposure is obtained passively – this tool provides long-term annualized real return and risk estimates for the liquid portion of an investor’s portfolio.¹

Last October, we launched a campaign called “The 5% Challenge” to see how many investors have liquid portfolios that, according to Research Affiliates’ forecasts, are poised to offer 5% annualized real return over the next decade. It’s startlingly hard to develop a portfolio where it’s reasonable to expect a 5% real return, over and above inflation. Since we launched our portfolio analysis tool last July, over 45,000 people have explored it; surprisingly few have created a hypothetical portfolio with the potential to deliver what many consider the industry standard of 5% annualized returns above inflation, according to our forecasts. So far, less than 700 have constructed portfolios with more than a 50% probability of earning a real return above 5%!

What gives? It’s not the fault of investors. We’re in a “zero yield world,” littered with assets trading at low yields and high prices. So, forward-looking returns look depressing relative to what many have grown accustomed to. That said, the vast majority of investors fail the hypothetical 5% Challenge due to their overreliance on mainstream, home-biased stocks and bonds, which are currently less attractive than their international counterparts. The classic U.S.-centric “60/40” stock/bond portfolio, for example, has a scant 1.1% real return expectation and less than a 1% likelihood of exceeding a 5% real return in the coming decade according to our forecasts (with stocks proxied by the S&P 500 Index and bonds by the Barclays U.S. Aggregate Index). Not your asset mix? We’ve also created both a “Public Pension”² portfolio and a “Barron’s Average”³ portfolio, which are meant to depict the average strategic asset allocations of a representative mix of two major investor groups: the nation’s pension plans and leading wealth management firms (with weightings derived from industry reports). While both the Public Pension and Barron’s Average portfolios see higher real return forecasts of a respective 2.6% and 2.4%, according to our estimates their probabilities of achieving a 5% annualized real return over the next decade only rise to 8% and 4%, respectively.

Are all investors relegated to such low probabilities of reaching their 5% real return targets? They don’t have to be. Creating a portfolio that feasibly targets 5% real over the long term is achievable for anyone who wants to think outside the box. Say, for example, we want a 50/50 portfolio of stocks and bonds. If we invest 25% in emerging market (EM) equities (which Research Affiliates forecasts will offer 7.5% real return for the next decade), 25% in Europe, Australasia and Far East or EAFE equities (5.8% forecast), 25% in U.S. high yield bonds (2.2% forecast), 15% in EM local currency bonds (4.3% forecast), and the remaining 10% in EM currencies (3.8% forecast), we’re there … a 5.2% weighted long-term real return forecast.⁴ (Please note this is a hypothetical portfolio utilizing return forecasts; it may or may not reflect actual future results.)

Of course, the estimated volatility of this passive portfolio rises to 14.8% versus the U.S.-centric 60/40 portfolio’s 8.9%. No wonder it’s difficult to deliver 5% real! For those unwilling to nearly double their volatility tolerance, the All Asset funds are potentially wonderful options. Not only have their historical volatility profiles hovered around 9% since inception, but they currently (as of 31 December 2016) offer attractive yields as well. At this stage in the cycle, it wouldn’t take a lot for the All Asset and All Asset All Authority funds to meet their secondary return benchmarks of CPI +5% and CPI +6.5%, respectively. Returns above and beyond these attractive yields potentially can be achieved as a consequence of PIMCO’s bond alpha, the potential equity alpha from the PIMCO RAE strategies (which Brandon discusses in detail below), and from mean reversion that might bring the long-term returns of cheap markets forward, allowing us to capture that return faster than expected.

At Research Affiliates, we’re not permabears at all. Right now, we’re bullish on several markets, and given our rigorously researched forecasts I am highly confident that we may perform way better than the 60/40 investor. It’s just that the markets we like are markets that frighten most people. Isn’t that just the way the world works?

Q: When taking equity exposure in the All Asset funds, it seems like there is a consistent emphasis on PIMCO RAE (Research Affiliates Equity) funds as opposed to PIMCO funds that provide market-cap-weighted equity exposure. What is the rationale for this, and how are these strategies utilized in the management of the All Asset funds?

Kunz: At Research Affiliates, our central philosophy is that the largest and most persistent active investment opportunities arise from long-horizon mean reversion. The All Asset funds seek to exploit this anomaly both across asset classes and within the equity markets. The PIMCO RAE (Research Affiliates Equity) funds are systematic active equity strategies that seek to deliver superior risk-adjusted returns by harvesting the returns provided by long-horizon mean reversion and other equity market anomalies. As of the end of 2016, these strategies received the lion’s share, 27.4 percentage points, of All Asset’s 30.5% total equity exposure, and 34.4 percentage points of All Asset All Authority’s 38.9% long-only equity exposure.

At their core, the PIMCO RAE funds are rebalancing strategies that break the link between the price of a stock and its weight in the portfolio. They begin with a portfolio that selects and weights companies by fundamental measures of size – gross profit, cash flow, dividends plus buybacks, and book value – and annually rebalances back to these anchor weights. This process provides a structural return advantage over capitalization-weighted indices by contratrading against the market’s most extreme bets. We sell the most newly beloved and extravagantly priced stocks, and we buy the most newly feared and unloved companies, trading at deep discounts. As prices tend to mean revert, the RAE strategy seeks to capture a rebalancing alpha.

While we believe the potential to capture the longer-term return advantage primarily comes from systematic rebalancing, we also see benefits from anchoring to fundamental measures of company size. Specifically, this tends to allow these strategies to retain the most desirable attributes of cap-weighted indices, including low turnover, vast capacity, high liquidity and broad representation of the macroeconomy.

Beyond the structural return advantage that comes from contrarian rebalancing, the PIMCO RAE strategies continuously evolve to incorporate active insights from our latest research. These insights are expected to enhance excess returns, reduce measures of risk, or accomplish a little of both. Currently, these active insights include financial health, momentum, diversification of style and diversification of size.

Financial health: There is a wealth of academic research demonstrating that financially healthy companies tend to outperform their less healthy counterparts, at the same valuation levels. With no universally accepted standard for measuring financial health, we include a comprehensive set of indicators designed to capture a company’s likely growth prospects, potential for distress and any accounting “red flags.” Intuitively, these financial health screens facilitate the avoidance of “value traps” (stocks that look cheap, on their way to zero!).

Momentum: There is also strong empirical evidence that price momentum is persistent over a span of months, but not years. By incorporating multiple measures of momentum into the PIMCO RAE strategies, we seek to create an equity portfolio that is intentionally patient in trimming expensive stocks that are on a roll, or buying cheap stocks that are in free fall.

Diversification of style: Certain companies provide unrecognized value because they possess various characteristics of relative attractiveness without having a strong correlation to the Fama-French value factor (which suggests that over the long term, value stocks tend to outperform growth stocks). The PIMCO RAE strategies increase their active weights to companies that exhibit these characteristics. This leads to not only improved portfolio diversification, but also the potential for higher risk-adjusted returns.

Diversification of size: The contrarian rebalancing we employ in the RAE strategies has potential to generate excess returns due to market inefficiencies. The less efficient the market, the greater the value add. Since large companies tend to garner more attention than small ones, the market tends to price small companies less efficiently than large ones. Accordingly, we increase RAE’s active weights (over- or underweight) in small companies and reduce active weights in large companies. Note that this is not the same thing as increasing our reliance on small companies.

The combination of a rules-based contrarian rebalancing chassis with these active insights leads to systematic active equity portfolios with an inherent value tilt. It is important to note, though, that this value tilt is dynamic. When value stocks become cheap (according to our defined parameters), the PIMCO RAE strategies automatically ratchet up their value tilt, and when value stocks become more expensive, the strategies similarly reduce their value bias. Empirically, we find that such strategies tend to outperform the most when value stocks are cheap and their value tilt is elevated … which is the environment we find ourselves in today.

How cheap are value stocks in today’s environment? As shown in Figure 1, and despite 9.3% outperformance over global growth stocks in 2016, global value stocks continue to trade near discounts to growth stocks not seen ever before, except for the extremes of the 1999–2000 tech bubble!

Given how cheap we believe global value stocks remain today, it shouldn’t be surprising to see elevated value tilts, and hence large average valuation discounts (based on price/sales, price/cash flow, price/dividends and price/book value ratios) versus the cap-weighted index. For example, the U.S., International and Emerging Markets PIMCO RAE Fundamental Funds began 2017 trading at considerable average valuation discounts of 30%, 29% and 39%, respectively (discounts derived from the average of price-to-sales, price-to-cash-flow, price-to-dividend and price-to-book ratios relative to capitalization-weighted indices). Should value stocks continue their rebound in 2017, we would expect the PIMCO RAE strategies to experience additional excess return tailwinds that further bolster their since-inception outperformance versus both passive indices and active managers.

There are also “PLUS” versions of the PIMCO RAE Fundamental strategies, which can and do appear within the All Asset fund portfolios. For any PIMCO RAE “PLUS” fund, PIMCO obtains the equity exposure via total return swaps, and then adds an absolute-return-oriented bond portfolio. If the bond strategy can beat Libor by more than a few tens of basis points, then overall performance has another alpha engine! The goal of these “PLUS” versions is to provide a PIMCO alpha, complementary to the RAE strategy alpha, without significantly increasing overall fund-level equity beta or volatility. This “PLUS” approach is not new to PIMCO. Since 1986 they’ve been managing bond alpha strategies in their “StocksPLUS” equity suite, and since 2005 they’ve been doing likewise for the PIMCO RAE PLUS funds with impressive results, as seen in Figure 2.

For the most recent quarter-end performance data for each fund, please click on the links below:

• PIMCO RAE Fundamental PLUS EMG Fund
• PIMCO RAE Fundamental PLUS Fund
• PIMCO RAE Fundamental PLUS International Fund
• PIMCO RAE Fundamental PLUS Small Fund

The longest-history RAE Fundamental PLUS fund has beat the S&P 500 by over 3% per year since its inception over 11 years ago. Top quartile results? Try top 1% of all core U.S. equity funds, out of over 500 funds in its Morningstar category! (See table above.) At Research Affiliates, we model an allocation to the RAE PLUS strategies as an efficient way to expose a single dollar’s allocation to multiple sources of return premia along with the alpha potential from the RAE equity exposure and PIMCO’s bond expertise. This is a key alpha engine for the All Asset fund, in U.S. large-cap and small-cap stocks, and in international and emerging market stocks; it can also be a key alpha engine for other investors who want an equity strategy with multiple sources of alpha.

In addition to the PLUS derivations of the PIMCO RAE Fundamental funds, we’ve also partnered with PIMCO to create Low Volatility PLUS derivations within the U.S., developed market ex U.S., and emerging markets. These PIMCO RAE Low Volatility PLUS funds are constructed similar to the “beta-one” RAE Fundamental PLUS versions, but we limit their universe to the most attractively priced low volatility stocks within each sector and country – and we continually rebalance in an effort to maintain a portfolio of what we believe are the cheapest low volatility stocks. These funds are designed to offer superior risk-adjusted returns, particularly relative to other low volatility options in the market today. We think these strategies are likely to deliver much lower downside risk, but – given how expensive low volatility stocks have become over the last decade – also somewhat lower returns than their beta-one PIMCO RAE Fundamental PLUS counterparts, which trade at steeper valuation discounts to the market. Still, given the All Asset suite’s search for maximum risk-adjusted returns, the potential volatility reduction of the PIMCO RAE Low Volatility PLUS strategies naturally leads to healthy allocations from the All Asset funds.

Finally, and because of their capacity and portability, our team at Research Affiliates has also partnered with PIMCO to deliver long/short and market-neutral derivations of the PIMCO RAE PLUS strategies. Current options include the Worldwide Long/Short PLUS Fund, which has a dynamic equity beta profile centered on 0.3 over the trailing three-year period through 31 December 2016, and the Fundamental Advantage PLUS funds, market neutral portfolios available with either a U.S. or global equity exposure. Because these strategies isolate the structural excess return potential from the RAE strategies and combine it with PIMCO’s absolute-return-oriented bond alpha strategy, they act as the All Asset suite’s return-seeking dry powder holdings that can either be readily increased to reduce overall volatility tolerance, or deployed into other arenas to take advantage of future market dislocations.

The various structures and regional focuses within the PIMCO RAE equity suite allow the All Asset funds to appropriately manage regional equity exposures, overall equity beta and fund-level volatility, all while providing the potential for superior excess returns complementary to the alpha generated by PIMCO’s portfolio managers. It’s for these reasons that, as of the end of 2016, the various flavors of the PIMCO RAE strategies received total cumulative allocations of 35.5% and 41.4%, respectively, from the All Asset and All Asset All Authority funds.

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.

Further reading

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

• Long-term asset class forecasts (January 2017)