All Asset All Access

All Asset All Access, June 2017

In this issue, Research Affiliates offers insight into the continued case for diversification amid an aging bull market for U.S. stocks and discusses how its ongoing, targeted research informs risk pricing across emerging and developed markets.

Rob Arnott, founding chairman and head of Research Affiliates, discusses the benefits of diversification amid the ninth year of a bull market for U.S. stocks, while Michael Aked, head of asset allocation, provides insight into Research Affiliates’ strong research culture and what current findings are telling us about risk pricing. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: In the ninth year of a bull market for mainstream U.S. stocks, how useful is diversification today?

Arnott: One of our colleagues, Jason Hsu, is fond of saying that diversification is a “regret maximizing” strategy. In a bull market, we regret having any diversifiers. In a bear market, we regret not having more. So true.

For that very reason, the answer to this question is more nuanced than it seems. For investors who are confident that this bull market will continue far into the future, why diversify? It’ll only hold you back! But for any investor who is wary about current U.S. stock market valuations, exceeded only in 1929 and during the tech bubble, diversification is utterly compelling today. In this second-longest bull market for U.S. stocks in the past century, the “buy low, sell high” truism is easily forgotten. It’s so much easier to say than to do. It takes courage to add to our diversifiers in the late stages of a bull market.

No one has a crystal ball to reveal when cycles will turn. But, as Keynes (and others) said, “trees don’t grow to the sky,” and market volatility will not remain subdued forever. Mean reversion of prices is unreliable in the short run, but relentless in the long run. Do we want some part of our portfolio to help us weather weak and choppy markets, or do we want our entire portfolio positioned only for an endless low-volatility, no-surprises bull market? Do we really think a bell will chime when it’s time for us to retreat?

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

The figure is a table showing the average annual total returns for the PIMCO All Asset Fund and PIMCO All Asset All Authority Fund, Institutional shares net of fees, for seven different trailing periods: three and six months; one, three, five, and 10 years, and since inception. The table also includes benchmarks. Detailed data as of 31 March 2017 are included within.

We’ve often discussed how our real-return-oriented strategies hedge against rising inflation expectations. We haven’t previously discussed how our strategies may also shine in two additional environments that can savage a mainstream 60/40 stock/bond portfolio: bear markets and turbulent markets. Let’s turn to the historical evidence. 

To provide an apples-to-apples comparison of our strategies with conventional 60/40 portfolios (see Figure 1), our analysis spans 13-and-a-half years, from the launch of the All Asset All Authority Fund on 31 October 2003 through the end of April 2017 (All Asset was launched in 2002).1 The 60/40 stock/bond portfolio is proxied by 60% S&P 500 Index and 40% Bloomberg Barclays U.S. Aggregate Bond Index. In down markets – when the S&P 500 delivered a negative 12-month rolling return – a 60/40 portfolio generated an average return of -9.50%.  How did our strategies fare in the same time periods? All Asset roughly halved the damage, returning an average of -5.32%, and All Authority was even more successful in abating the loss, delivering an average return of -0.90%.

Figure 1 is a bar chart showing the performance of the All Asset and All Asset All Authority funds (Institutional shares, net of fees) compared with a 60/40 portfolio, with two scenarios: down markets and choppy markets. On the left, showing down markets, a bar dropping downward from zero shows a loss of 5.32% for the All Asset Fund, and a loss of 0.9% for the All Asset All Authority Fund, compared with losses for a 60/40 portfolio of 9.5%. For choppy markets, shown on the right, the All Asset Fund loses 3.87%, and the All Asset All Authority Fund gains 85 basis points. In this scenario, a 60/40 portfolio loses 10.86%.

Volatile markets – characterized by an average rolling 12-month volatility exceeding 20% – tended to be even more brutal for 60/40 portfolios, which fell by 10.86% in these periods. Our strategies performed meaningfully better in volatile markets: For All Asset, the average return was -3.87%, and for All Authority, these periods of turbulence saw an average gain of 0.85%!

Do the results surprise us? Not at all. These strategies are intended to be diversifiers, specifically designed to add value when a conventional portfolio is likely to struggle. With additional tools of leverage and shorting, All Authority, while riskier, is a more differentiated Third Pillar strategy (focused on diversifying markets – including real assets, emerging markets and high yield bonds), offering more “maverick risk” than the All Asset Fund. Both have tended to fare well when inflation expectations are rising, and both seek to mitigate bear market damage. Because All Asset is a long-only strategy, it may not offer the full hedge potential of All Authority in bear markets, but we still think it offers an attractive source of diversification. And both are designed to thrive in turbulent markets.

During the life of the All Asset strategies, we’ve seen disinflationary markets some 70% of the time, with rising equity markets and low volatility over 80% of the time. Two observations: First, even in these conditions, which tend to be difficult for diversifying Third Pillar assets, our strategies delivered respectable positive returns. For instance, in euphoric environments where the average 12-month return of the S&P 500 Index was 10% or more, the average 12-month return was 10.19% for All Asset and 8.07% for All Authority. Second, markets can become surprisingly savage with little warning. Do we put our diversifiers in place now, when there’s no evident need, or after markets have already inflicted damage and the need for diversification is self-evident? The question answers itself.

While we’d be naïve to try to time the turn, U.S. stocks seem ripe for reversal, with disappointment or turbulence likely to strike in the not-too-distant future. Our research shows that since 1802, the average length of a bull market that maintains over 10% in annual returns without experiencing a 20% decline has been just over three-and-a-half years. At eight years and counting, the current rally is in the top decile of all historical U.S. bull stock runs, as are current valuations. Indeed, price-to-sales ratios recently exceeded the levels of the tech bubble to achieve new all-time highs. Similarly, since 1802, non-volatile periods for U.S. equity markets have typically averaged about six years, putting this current quiet state within the longest quartile.

Meanwhile, since the Third Pillar hit its bear market lows in January 2016, our strategies have already surpassed 60/40 portfolios by more than 6.50%, delivering cumulative returns of 27.63% for All Asset and 27.20% for All Authority as of 15 May 2017. Is there still room to run? No one knows. But just as an eight-year bull market in U.S. stocks is very mature, a one-year bull market in Third Pillar markets is still very young. We are highly confident in our ability to beat the conventional 60/40 balanced investment over the coming five to 10 years.

Do you really think inflation and volatility will forever remain benign, and bear markets will forever be averted? If so, these diversifiers may not be appealing. But if you think inflation, volatility or a bear market are reasonable possibilities in today’s frothy markets, we believe All Asset and All Asset All Authority are well worth consideration.

Q. What are your latest research findings, and how might they be incorporated into the management of the All Asset strategies?

Aked: At Research Affiliates, true to our name, research is an essential ongoing endeavor as we strive to further our understanding and apply our research insights for the benefit of investors. In previous issues of All Asset All Access, I’ve said that we believe a fair assessment of value should be the basis of future prices and that long-term mean reversion is the most persistent active investment opportunity at our disposal. Given these investment beliefs, we have extensively studied macroeconomic conditions and their intersection with global asset allocation to improve our understanding and assessment of an asset’s fair value, a number that can never definitively be known.

Specifically, our recent work has focused on quantifying the “riskiness” of a given country and using that to refine our estimation of fair value for that country’s stock market, which in turn helps us to estimate the appropriate risk premium for an equity investment in that country. The key measure we use to assess riskiness is macroeconomic volatility (as detailed in our publication “Quest for the Holy Grail: The Fair Value of the Equity Market”2). Simply put, when there is lower macroeconomic volatility, there is less market uncertainty, which supports higher average valuations (and vice versa). What we find in the U.S. today is that the level of macroeconomic volatility is at a historical low, having tumbled profoundly in the decades since the start of the Great Moderation in the mid-1980s. While this basement-bottom volatility may justify a higher fair value than the long-term historical average – making U.S. stocks today look less expensive than they otherwise would – they are still priced at lofty levels even net of this adjustment, so our lack of appetite for U.S. stocks remains largely unchanged.

We are currently extending our analysis to consider the impact of macroeconomic uncertainty for the broad range of countries we invest in, both developed and emerging markets. While a country’s level of macroeconomic volatility offers useful information about the risks of investing in large, developed economies, it has proved less useful in more regulated markets. We recognize that there may be caveats to relying solely on macroeconomic volatility as a universal descriptor of macro risk when comparing one country with another. For instance, a country with a more authoritarian power structure could maintain a level of low macroeconomic volatility but embody a substantial level of economic uncertainty. Because it’s entirely possible for a leadership regime to effectively manipulate macroeconomic volatility, we believe it is a less reliable proxy of a country’s inherent risk. So, when extending our approach, we consider additional metrics that we believe may be equally suitable if not superior proxies for country-level risks.

Over the last half-century, various studies have shown that the structure and maturity of institutions such as courts, political bodies and central banks – and, importantly, the trust and faith citizens place in them – meaningfully coincide with a country’s stability, productivity gains and income level. There are various measures that attempt to assess governance and institutional quality, including the security of private property, enforceability of contracts and strength of property rights, along with the level of political instability, quality of government services and evidence of corruption, among others. The Worldwide Governance Indicators project has taken on the task of reporting and updating metrics for the past 20 years (1996–2015). We can also gain longer histories for subsets of like indicators from various studies, such as the Polity IV Project and the PRS Group’s International Country Risk Guide.

The benefits of higher-quality institutions have been well-documented and are thought to be a prerequisite for a country’s macroeconomic success. Unsurprisingly, we’ve found that institutions designed to enforce contracts and protect ownership are weaker in emerging market (EM) countries relative to the U.S. and more established countries. A country with lower institutional quality is accompanied by a lower average income, lower growth and higher risks to investors. There is a price to undertaking such risks, and quantifying them would allow us to understand whether markets are over- or undercompensating investors. By extending our research globally, we gain insight into these questions: Are the higher risks present in Europe, Australasia and Far East (EAFE) and EM stock markets reflected in today’s prices? And how much additional premium should we demand for less established jurisdictions?

A glance at Figure 2 suggests that more developed countries have stronger institutions. The U.S. has an average institutional quality score of 7 (out of a possible 10, as measured by the PRS Group), while that for other developed economies is slightly lower, at 6.7. The mark for emerging markets, at 5.4, is even lower but still meaningfully above the frontier markets average of 4.3. Historically, looking over the last 30 years at developed and emerging economies, the market has applied a discount of about 2.5 cyclically adjusted price-to-earnings ratio (CAPE) points for each unit of institutional quality. This implies that, at current levels of maturity, the EAFE and EM markets would require CAPE discounts of about 1 and 4 points apiece, much less than the current discounts being priced into offshore markets.

Figure 2 is a scatterplot of countries’ logarithmically tracked GDP per capita, shown on the Y-axis, versus their average institutional quality score. The plots range in log GDP per capita of roughly 7 to 11, and quality ranging from 3 to more than 7. All of the plots center around an upward sloping line, with those for the developed countries residing in the upper right-hand section, with log GDP per capital of roughly 10 to 11 and quality between 5.5 and 7.3. Emerging countries are grouped in the middle of the sloping line, with log GDP per capital of about 9 to 10, and quality of 3 to 7. Frontier countries are on the bottom of the graph, with log GDP per capital of roughly 7 to 9, and quality ranging from 3 to 6.

It is often riskier to invest outside the U.S., and doing so should come with higher return potential. The macroeconomic risk driven by the quality of institutions that govern these markets is higher. We believe these markets are priced to offer long-term real return potential, as reflected by our portfolio positioning; at the end of April 2017, All Asset and All Authority included substantial exposure to EM and EAFE asset classes. While the underlying economies and markets have recently improved – which may have lowered their prospective attractiveness – a substantial cushion remains.

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:

  • Continued opportunities in emerging markets (May 2017)
  • Benefits of active investment management in “third pillar” assets (April 2017)
  • Where conventional wisdom may be making mistakes in today’s market (March 2017)
  • Contrarian strategies to enhance real return (February 2017)
  • Long-term asset class forecasts (January 2017)

1 There are many ways to slice-and-dice market environments. We measured results using the following scenarios: 1) up, quiet, and down markets; and 2) calm, sideways, and choppy markets. In the first set, an “up” market means the S&P 500 Index returned above 10%; “down” means it fell below 0%; and “quiet” covers all remaining instances. Returns are based on 12-month rolling spans. In the second set, calm markets exhibit an average 12-month volatility below 10; choppy markets, above 20; and sideways markets include everything in between. The 12-month volatility is calculated as a root-mean-square return, adjusted for serial correlation. Older data tend to exhibit large serial correlation, resulting in an understated volatility figure.

2 Aked, Michael, Michele Mazzoleni and Omid Shakernia. “Quest for the Holy Grail: The Fair Value of the Equity Market.” Research Affiliates, March 2017.
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Robert Arnott

Founder and Chairman, Research Affiliates

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