Rob Arnott, founder and chairman of Research Affiliates, examines some of the less obvious potential benefits of allocating to the All Asset strategies, while asset allocation specialist Omid Shakernia discusses what drives Research Affiliates’ approach to trading into and out of positions. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: In past issues you’ve discussed sources of potential value that the All Asset strategies provide to investor portfolios. What additional benefits might the strategies offer that tend to be overlooked?
Arnott: For nearly 17 years, we’ve designed and managed the All Asset strategies to complement investors’ mainstream investments by serving as a source of true diversification potential: seeking to diversify away from mainstream equity market risk, counter investors’ vulnerability to inflation, and provide potential for real returns when conventional stocks and bonds may not be able to.
Many investors are gradually allocating more to diversifying assets (what we call “Third Pillar” asset classes, including real assets, emerging markets, and high yield bonds), particularly compared with the minimal allocations investors tended to have when we launched these strategies in 2002 and 2003. Even so, for most investors, the vast majority of portfolio exposures still reside in mainstream stocks and bonds.1 In what is now the longest expansion and bull market in U.S. history, we think our strategies play a more important role in our clients’ portfolios than ever.
The All Asset strategies deliberately seek and favor assets that 1) diversify away from mainstream stocks and bonds; 2) offer potential for higher yield, faster growth, or both, than mainstream stocks and bonds; 3) have a relatively low correlation with the mainstream markets; and 4) exhibit a historically positive correlation with inflation shocks, to provide a source of real return potential in the event of renewed inflation. We think the time to embrace this kind of strategy is when inflation fears are at a low ebb and when mainstream markets are fully priced.
We’ve regularly shared a few key sources of long-term return potential for the All Asset strategies. These include the potential value added from continual rebalancing across a vast span of markets as valuations fluctuate; the ability to access active management alpha potential from the underlying PIMCO funds, drawing from the firm’s deep bench of specialized investment talent; and the opportunity to tap into structural return sources, notably by allocating to PIMCO funds that blend smart beta alpha potential with PIMCO’s portable bond alpha. These sources combine to create a powerful three-in-one driver of excess return potential that we believe makes the All Asset funds a compelling way for investors to access diversifying and inflation-sensitive markets, especially compared to obtaining comparable beta exposures through passive index approaches.
Let’s now turn to the underappreciated potential benefits our strategies offer. First, and crucially, the All Asset strategies institutionalize the discipline (and courage!) required to execute a contrarian philosophy. The ability to profit from mean reversion requires embracing the discomfort inherent in buying what’s out of favor (cheap) and selling what has appreciated (rich). Though this sounds straightforward, practicing a contrarian discipline goes against human nature. Return-chasing is a well-documented behavioral tendency that has lowered returns for many investors, and the All Asset strategies explicitly seek to counter that tendency.
Second, the All Asset strategies aim to ratchet up sustainable real spending2 in seeking to build true wealth for investors. Rather than measure wealth in dollars for immediate spending, we believe the focus should be on the real spending – purchasing power net of inflation – that our assets can sustain over the long-horizon future. That is why we center our contra-trading on rotating out of expensive assets and into bargains trading at attractive risk premiums, focusing on Third Pillar assets or a mix of assets with higher average correlations to inflation than mainstream stocks and bonds. The result is a return stream that has exhibited comparable nominal volatility since inception3 to a classic 60% stock /40% bond blend (of 8.43% for a 60% S&P 500 and 40% Bloomberg Barclays U.S. Aggregate Bond Index portfolio), but is designed to seek much less real volatility – that is, when returns are viewed net of inflation. Therefore, for clients seeking to build real spending power, these strategies aim to stabilize sustainable long-term real spending and help reduce inflation uncertainty, even if some of the markets we like best today seem riskier than mainstream assets.
Lastly, investors might value that the All Asset strategies may reduce the “line-item costs” that can come with allocating to a diversifying mix of funds, asset classes, and strategies. This is particularly relevant to financial advisors and consultants who realize that making dedicated allocations to individual asset classes that are well outside the mainstream often comes with substantial educational, administrative, and ongoing oversight burdens. The result may be a costly shift of time and resources away from other more valuable activities. By contrast, the All Asset strategies collapse these exposures into a single line item that seeks to provide broad diversification and thoughtful rebalancing therein, based on changing relative attractiveness.
Q: What is your approach to trading into and out of positions in the All Asset strategies?
Shakernia: Our approach to trading in the All Asset strategies is guided by a maxim akin to the Hippocratic Oath: “First, do no harm.” By “harm,” for both the All Asset strategies and the underlying funds in which we invest, we mean the negative performance drag that may arise from transaction costs and market-impact costs due to unnecessary or haphazard turnover.
The nature of our tactical approach puts us in a potentially favorable starting position: As contrarians, we typically seek to buy what the market is selling, and vice versa. This means we are typically liquidity providers, not takers. Also, our tactical horizon is not “fast twitch”; we typically move into or out of positions over weeks to months and hold them for one to three years. Nevertheless, we still adhere to our “no harm” objective by instilling several disciplines into our systematic trading process, which is implemented via our underlying “Calypso” asset allocation infrastructure (see our April 2019 issue for more information).
In summary, the All Asset trading process includes the following activities: 1) updating trade target allocations in response to material changes in our model portfolio allocations; 2) using daily inflows and outflows to trade toward our target allocations; and 3) coordinating with underlying PIMCO fund portfolio managers on sizing and scheduling trades based on the liquidity in the funds’ markets.
The first step in the trading process involves the creation of the “model” portfolio allocations. The All Asset strategies rely on model-driven processes that begin with fundamental, market, and macroeconomic data to model estimated returns and risks for the underlying PIMCO funds in the All Asset universe. A bespoke mean-variance optimization process incorporates these inputs daily to provide target allocations for the model portfolio. To avoid unnecessary costs and excess turnover, we do not trade directly to these daily model allocations, which can pick up small market moves that could result in unprofitable trades. The portfolio management team instead updates target trade portfolios only when the models indicate meaningful trades, above specified thresholds.
For the second step in the process, we have developed an automated “trade calculator” in seeking to optimize portfolio shifts; specifically, how to efficiently move the live portfolio to the target weights while minimizing market-impact costs. The trade calculator includes rules to incorporate fund flows in this trading optimization. Essentially, we use fund inflows to buy underweighted assets and outflows to sell overweighted assets. In so doing, we need only trade a subset of the portfolio to move to our targets, which helps minimize unnecessary trades and associated trading costs.
Because the holding period of the All Asset strategies is usually between one to three years, we have the luxury of being patient in our trading; we can move into or out of a position over days or in some cases weeks in seeking the best execution. This is where step three comes in: To minimize market-impact costs, we regularly coordinate with the PIMCO fund portfolio managers to better understand the liquidity conditions in their underlying markets, helping us to optimally size and schedule our trades.
Lastly, we reiterate that the most critical element in our “do no harm” trading maxim comes from the fundamental tenet of the All Asset investment process itself. Since All Asset is predominantly a value-driven strategy, our investment process systematically trades out of recent winners and into cheaper asset classes that may be out of favor but that we believe have high forward-looking return potential. This generates trading patterns that are contrarian to the bulk of investor flows, which tend to be performance-chasing. These contrarian, liquidity-providing trading patterns can actually help the underlying portfolio managers to better manage liquidity within their individual funds as part of their efforts to deliver alpha, which is to the benefit of all.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:
- What an embrace of Modern Monetary Theory could mean for inflation and how PIMCO uses machine learning applications (June 2019)
- The role of machine learning in quantitative investment models and factors driving current risk tolerance within the All Asset strategies (May 2019)
- Differences between the All Asset and All Authority strategies, and their underlying allocation infrastructure (April 2019)
- 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)
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 The allocation to developed equities and bonds totaled over 70% as of 31 May 2019 for the Barron’s Penta portfolio.
2 Interested readers can learn more in my Editor’s Corner piece, “Sustainable Spending in a Lower-Return World,” published in the September/October 2004 issue of the Financial Analysts Journal.
3 Volatility is 8.59% since inception (31 July 2002) for All Asset and 8.69% since inception (31 October 2003) for All Asset All Authority; 8.43% volatility for a 60/40 portfolio is for the period since All Asset’s inception through 30 June 2019.