Founder and chairman of Research Affiliates, Rob Arnott, discusses how the firm assesses attractive return opportunities and the role of the All Asset strategies in portfolios. Jim Masturzo, partner and head of asset allocation research of Research Affiliates, explains why the firm believes value-oriented stocks remain compelling and how the All Asset strategies are positioned to benefit. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.
Q: Let’s start with your approach to identifying market return opportunities. How do you research and estimate long-term market return forecasts?
Arnott: Conceptually, any investment can produce returns in three ways: income, growth (or deterioration) in income, and changes in valuation levels (or yields for bonds). At Research Affiliates, our models use these three building blocks to derive long-term buy-and-hold asset class return forecasts. For any investment or index, we know the current yield, and we know the long-term historical growth in income (typically zero for fixed income, inflation-plus for stocks, negative for high yield bonds with occasional defaults). Absent any change in valuation multiples or yields, those are the building blocks of the long-term return. In our forecasting approach, we then include a mild nod to mean reversion: Valuation multiples, yields, and spreads have shown a powerful tendency to eventually mean-revert toward historical norms. However, since mean reversion is somewhat unpredictable, our models only assume partial mean reversion – spread out over the decade to come – in setting our return forecasts.
Thoughtful asset class return forecasts are essential to the management of the All Asset portfolios. When applied to historical data, Research Affiliates’ building blocks approach has been notably accurate: Most of these 10-year forecasts since 1971 were within about 2 percentage points of the subsequent 10-year actual real returns. (For details, please see the November 2020 All Asset All Access.) So, if we see a 10 percentage point spread in current forecasts, we sit up and take notice! By objectively forecasting potential returns using a disciplined approach, we can focus our attention on comparative valuation levels that are at odds with market perceptions.
Our models guide us to average into what we deem to be cheaply valued asset classes at times when they are generally feared and shunned, helping us make the uncomfortable trades required when seeking to profit from contrarian investing over time. Through these same models, we also gradually shift away from what we deem to be richly valued asset classes with fading return prospects in environments of complacency. In short, our approach at Research Affiliates helps ensure a reliable contrarian rebalancing discipline is inherent within the All Asset strategies.
Q: Before we delve into opportunities, what role do the All Asset strategies tend to serve in investor portfolios?
Arnott: All Asset is a focused “Third Pillar” strategy (our term for a diversifying approach incorporating real return assets, high yield bonds, and emerging markets (EM)), while All Asset All Authority is even more powerfully divergent, hence more diversifying. We do not advocate that investors use the All Asset strategies instead of mainstream stocks and bonds; instead our strategies serve as a diversifying complement to an investor’s existing allocations to mainstream stocks and bonds.
Our friend and former colleague, Jason Hsu, likes to describe diversification as “regret maximizing.” Because diversification can feel so uncomfortable in a bull market, many investors anchored on a mainstream 60/40 stock/bond mix regret their diversifiers; some even slash their diversifying assets to chase the kinds of assets that we now believe are in bubble territory. As a result, many investors today may lack sufficient diversification away from U.S.-centric equity risk – and in our view, this means they face low prospective returns on their conventional holdings and are vulnerable to renewed inflation.
These issues are arguably more urgent today than any time since the launch of the All Asset strategies in 2002. Just as the 2000s saw a stark reversal of the go-go 1990s (which ended in a tech-led equity bubble), we believe the 2020s could similarly deliver a stark reversal on current speculative growth holdings (many of which appear to be in bubble territory once again).
Q: Where does Research Affiliates see opportunities for attractive potential multi-year returns?
Arnott: As we scan capital markets today, we find that among the roster of diversifying markets, developed market ex U.S. equities (proxied by the MSCI EAFE (Europe, Australasia, and the Far East) Index) are trading at prices that generate a high relative yield, which in turn positions them for a long-term forward-looking estimated nominal return of 6% (4% real), according to our model. We estimate emerging market equities (proxy: MSCI EM Index) are priced to deliver about 2 percentage points more than this, albeit at higher risk.
Within the All Asset suite, we typically access these markets using the PIMCO RAE strategies, which generally have a stark value tilt. Our smart beta research forecasts value stocks to beat the broader stock market by roughly 4 to 5 percentage points per annum over the coming five years, suggesting the potential for even more attractive returns in international and EM equities (value stocks are proxied by companies selected from the broader equity universe on the basis of a value score, which Research Affiliates calculates from price, earnings, and other data and weights by market capitalization; the broader stock market is proxied by the top 500 stocks by market cap (U.S.) and all stocks in the large and mid cap starting universe (developed and emerging markets), weighted by market capitalization).
Unsurprisingly, the All Asset strategies have increased their allocations to international stocks over the last year (albeit some coming from EM stocks, where the momentum is – for now – less encouraging). As of 31 December 2020, the allocation to developed ex U.S. equity strategies is 14.4% in the All Asset strategy and 14.3% in the All Asset All Authority strategy.
Another Third Pillar market we have opportunistically shifted into is real estate investment trusts REITs, which in our estimates are poised to deliver a long-term nominal return of 4% over the coming decade (proxy: FTSE NAREIT All Equity REIT Index). As of 30 December 2020, REITs and commodities combined represented a 15.0% allocation in the All Asset Fund and a 13.4% allocation in the All Asset All Authority Fund.
Relative to diversifying markets, our long-term nominal return forecasts for mainstream U.S. stocks and bonds are paltry, ranging from −1% per annum for U.S. long Treasuries (proxy: Bloomberg Barclays U.S. Treasury Long Index) to 2% for U.S. large stocks (proxy: S&P 500). Research Affiliates’ model finds the conventional 60/40 portfolio (with 60% equities proxied by the S&P 500 and 40% bonds proxied by the Bloomberg Barclays U.S. Aggregate Bond Index) is priced to deliver a return of 1.8% in nominal terms, and a shocking shortfall of −0.4% per annum(!) net of inflation, Footnote[i]over the coming decade.
As we’ve noted, value-oriented stocks remain extraordinarily compelling. The pandemic year of 2020 was the single worst year for value strategies in my career. We have to go back to 1931 to find a year remotely this bad for value. We all understand the reasons for the shortfall: Tech/growth stocks seem to have been ideally positioned to thrive amid COVID-19 (and the lasting changes we’ll see in a post-pandemic world), while value stocks demonstrated anemic growth (or worse) and skinny profit margins in 2020, exposing them to greater bankruptcy risk. But how much of this narrative is not already reflected in prices? Across many regions, relative to their growth counterparts, value stocks are trading close to the cheapest levels they ever have over the past four decades where data is available. We believe this is a remarkable opportunity for value investors, as my colleague Jim Masturzo will discuss in more detail.
Q: Before we turn to value-oriented asset classes, does Research Affiliates believe all equity markets are frothy?
Masturzo: Several metrics indicate U.S. stock markets have been trading at rich valuations (relative to historical averages) for some time now. For example, we note the ratio of the total market capitalization of U.S. equities (proxied by the Wilshire 5000) compared with U.S. gross domestic product (GDP) has now risen to 160% as of Q4 2020. Not only are U.S. stocks valued at 60% more than U.S. GDP, but the current value is roughly double the average since 1975 of just under 80% (sources: Bloomberg and the U.S. Bureau of Economic Analysis or BEA).
Focusing on just large cap equities, the S&P 500 is also trading rich with a cyclically adjusted price/earnings (CAPE) multiple of 33.5 and a long-term median value of 16.
We note the froth does not appear to extend to global equity markets. For example, developed markets outside the U.S. are trading at a CAPE multiple of close to 18, while emerging markets trade close to 16.5.
Q: Why would investors consider allocations to value-oriented asset classes when most mainstream equity markets appear to be approaching all-time highs?
Masturzo: Although the All Asset strategies do at times invest in pure capitalization-weighted equity indices, the opportunity set includes a range of attractive value-oriented strategies as well. Similar to their cap-weighted counterparts, both developed market and emerging market value indices are trading at CAPE ratios well below their long-term averages: As of December 2020, developed markets (proxied by MSCI EAFE Value Index) were trading at a CAPE of 12 against an average of 19, while the comparison is 10 versus 14 for EM (proxied by MSCI EM Value Index). Even in the U.S, the Russell 1000 Value Index CAPE appears fairly priced at its long-term average.
When compared with growth counterparts, value-based indices have tended to cheapen over much of the last decade, and even more so in the last year or two. Figure 1 shows the ratio from dividing the CAPE of a cap-weighted value index by the CAPE of the corresponding growth index. In each region, value has gotten cheaper relative to growth, an illustration of the generally poor relative performance of value stocks in the 2010s.
Figure 1: The ratio of value CAPE to growth CAPE (1978–2020) indicates growth has outpaced value for much of the past decade
The good news is that the cheaper prices of value-based strategies mean this may be an attractive time to invest in these assets. Our research finds that at current valuation levels, value-based strategies historically have tended to perform well over subsequent five-year periods, with annualized excess returns on the order of 5%–15%. And remember that in the All Asset portfolios specifically, much of the equity exposure is obtained through the PIMCO RAE PLUS suite, which combines return from the equity exposure with incremental return potential from the actively managed collateral and any associated alpha.
Q: Finally, how is Research Affiliates positioning the All Asset strategies in this environment?
Masturzo: The All Asset portfolios are currently near all-time high exposure levels in value-based equity strategies. We note that neither developed ex U.S. (EAFE) stocks nor emerging market equities are expensive, and value strategies have continued to cheapen.
An additional tailwind we see for investing in value stocks is that compared with cap-weighted value indices, PIMCO RAE strategies – which are the bulk of All Asset equity exposure – historically tend to trade at multiples cheaper than their cap-weighted counterparts in both the U.S. and emerging markets, and close to parity in developed ex U.S. international markets.
RAE strategies also have the systematic ability to ratchet up value exposure when value is more attractive, as it appears today. The All Asset strategies are positioned to take advantage of the potential opportunities afforded by buying these assets at a discount, while trimming exposure to some other asset classes, fixed income in particular, that currently appear to trade at significantly negative yields adjusted for inflation.
Institutional investors and financial professionals: Register here for the All Asset webcast on 11 March 2021 to learn more about the All Asset strategy and outlook.
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.