Christopher Brightman, CIO of Research Affiliates, discusses why investors in the All Asset strategies should assess risk more as the potential to meet (or miss) wealth accumulation goals, and less as a function of short-term price changes or returns relative to traditional benchmarks. Katy Sherrerd, CEO of Research Affiliates, discusses how a corporate culture that fosters collective intelligence while avoiding groupthink leads to winning outcomes for the firm’s employees, partners and clients. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: What are the biggest risks facing investors in the All Asset strategies?
Brightman: Like all portfolios composed of capital market securities, the All Asset strategies expose investors to the absolute risk of short-term price changes. Investment professionals often quantify this short-term price risk using annualized standard deviation of returns, a statistical measure more commonly referred to as “volatility.” We believe a level of volatility of around 10% is appropriate for multi-asset portfolios, including those that center on Third Pillar assets (including real assets, emerging markets and high yield bonds). That level is roughly between the levels for stocks and bonds, given approximate long-term historical volatility of around 15% for the U.S. stock market and around 5% for an aggregate bond market portfolio (proxied by the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index, respectively).
What does an annualized volatility of 10% mean? For a hypothetical normal return distribution with an average annual real return of 5% and volatility of 10%, in two years out of three, the annual real return will fall within a range of −5% and +15%. This range is the “fat middle” of the distribution of potential returns. But let’s not forget about the tails of the distribution. In one year out of 20, the annual real return drawn from this hypothetical distribution will fall outside of the range of −15% and +25%.
Let’s now shift our focus for a moment from absolute risk to relative risk, or what we refer to as “maverick risk.” We believe John Maynard Keynes’ maxim pithily expresses the idea behind maverick risk: that it is more acceptable “to fail conventionally than to succeed unconventionally.”1 From a maverick risk perspective, return outcomes are measured on a relative basis, versus peers or traditional benchmarks. Because the All Asset strategies are designed and managed to serve as investors’ source of diversification away from mainstream stocks and bonds, investors in these strategies will of course experience ample maverick risk. Though interestingly, this measurement of risk says little about an investor’s absolute outcome.
Investment professionals quantify maverick risk as the standard deviation of the difference in returns between a portfolio and its benchmark, commonly called tracking error. The tracking error of the All Asset strategy relative to its primary benchmark (Bloomberg Barclays U.S. TIPS 1–10 Year Index) has been 6.53%, and the tracking error of the All Asset All Authority strategy relative to its primary benchmark (the S&P 500) has been 11.34% (since inception, through 28 February 2019).
Returning to absolute risk in the near term, what events could cause a large decline in prices for capital market securities over the coming months? We can readily identify hypothetical and entirely plausible economic or geopolitical scenarios that might cause investors to try to reduce their exposure to risk assets in concert. For instance, a disorderly liquidity squeeze could be the unintentional result of quantitative tightening, a debt crisis in China triggered by a trade war with the U.S., or a solvency crisis for European banks precipitated by a hard Brexit. Of course, these potential problems aren't mutually exclusive; we could very well experience two or even all three in 2019.
Key to a more complete understanding of capital market risk, however, is the observation that market crashes often follow long periods of rising prices without any obvious geopolitical or economic catalyst – for example, the popping of the Japanese bubble in stocks and real estate in 1990 and the collapse of global technology stocks in 2000. From these historical events, we believe that high-priced, low-yielding assets, such as developed market government bonds and U.S. stocks today, might have lower potential to meet long-term goals than lower-priced, higher-yielding assets, such as high yield bonds and emerging market equities today.
For long-term investors, risk may be defined less by the short-term price changes of securities within our portfolios and more by the potential failure to meet our wealth accumulation goals. Accordingly, a more appropriate, if admittedly less precise, quantification of risk for long-term investors may be an estimated probability of reaching, or failing to reach, long-term return requirements. Research Affiliates offers investors interactive tools to help quantify the probability of a portfolio achieving a range of real returns over a 10-year horizon using transparent and well-documented methodologies for estimating asset class and portfolio return forecasts.
We believe today’s high prices and low yields for a traditional portfolio consisting of 60% U.S. stocks and 40% U.S. aggregate bonds may present a significant risk to investors, in terms of an inability to meet long-term wealth accumulation goals. Our methodologies estimate that a traditional 60/40 portfolio (proxied by the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index) has less than a 50% probability of producing more than a 2.5% annualized real return, and a small but significant probability of producing less than 0% real return over the coming decade.
In contrast, for a portfolio favoring lower-priced and higher-yielding assets, such as “Third Pillar” assets including non-U.S. stocks and credit strategies,2 this methodology estimates a greater than 50% probability of achieving a 4% real return or above and less than a 5% probability of achieving a 1% real return or below over the coming decade. In other words, we believe this style of portfolio, in the go-forward environment, presents less risk to investors as defined by a likelihood of meeting long-term wealth accumulation goals, even though it may have elevated levels of maverick risk (or return differentials) relative to traditional benchmarks.
Said plainly, for long-term investors, we believe high prices and low yields indicate a lower potential to meet longer-term goals, while the reverse is true for low prices and high yields – and volatility provides opportunity. In the current environment, we think investors should consider Keynes’ maxim – and the tradeoff between failing conventionally and succeeding unconventionally – very carefully.
Q: How will Research Affiliates’ recent governance changes, including your transition to CEO, influence management of the All Asset strategies?
Sherrerd: Quite simply, the management of the All Asset strategies benefits tremendously from our long-held commitment to creating a corporate culture that allows teams to perform at their highest levels. I am a big proponent of the benefits of collective intelligence – particularly in our industry, where even the smartest member of a team can benefit from hearing different points of view – and the need to be deliberate in creating an environment conducive to productive collaboration.
Over the past four decades, my passion and experience have centered on management and leadership in the investment industry, which is complementary to the primary skills of my partners – and co-portfolio managers for the All Asset strategies – Rob Arnott and Chris Brightman. I joined Research Affiliates in November 2006 to help build a high-functioning and sustainable firm, and one of our early initiatives was to cultivate a corporate culture that would support winning outcomes for our clients, partners and employees. A key driver of our culture then, as it is today, was a shared belief in the benefits of collaboration and the value of diverse opinions.
In a recent piece titled “The Winning Formula,” I shared three elements of our firm’s management that I view as crucial for long-term success: mission, team and culture. The influence of firm culture is deeper and more impactful than many assume. First, a culture founded on core values3 inherently influences our people, who are critical to the long-term success of our firm, our partners and our clients. Leadership, research, strategy development, product development and relationship management efforts that benefit the All Asset strategies all spring forth from our people.
Second, and importantly, beyond supporting individuals alone, a sustainable culture has the potential to foster high-functioning teams and raise levels of collective intelligence. Studies have shown that randomly selected groups of people perform better than the single most intelligent person (as measured by IQ) in the group. And based on my research, a corporate culture that embraces diversity and nurtures inclusion raises collective intelligence levels and reduces groupthink, which in turn leads to more effective leadership and management practices, better decision-making outcomes and greater creativity and innovation.4 Accordingly, we are intentional about fostering two elements necessary for raising collective intelligence levels and minimizing groupthink: 1) ensuring cognitively diverse teams and 2) fostering environments that value curiosity, respect and independent – particularly dissenting – views.
Our advisors at Research Affiliates have studied the relationship between culture and long-term value, and the results support our approach. In a 2011 study,5 Alex Edmans found that firms whose employees have high levels of job satisfaction – as measured by those listed in Fortune magazine’s “100 Best Companies to Work for in America” – also tend to deliver high long-term stock returns. Over a 26-year span ending 2009, these firms beat their peers by 2.4% to 3.7% per year. And in a 2018 study, Campbell R. Harvey and his coauthors also found that cultural values and norms are positively correlated with firm value, innovation and ethical outcomes.6
Over the past decade, we have embraced the importance of building a high-functioning, sustainable culture. In a world and an industry where the only constant is change, this commitment is essential to deliver on our mission of conducting research and advancing innovative products for the benefit of investors in the All Asset strategies.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:
- 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)
- Market impact of the U.S. midterm elections and what differentiates All Asset’s positioning versus peers (December 2018)
- Outlook for achieving All Asset’s long-term real return benchmark and its approach to assessing country risk (November 2018)
- Three key ways to “bucket” the All Asset strategies and a recap of year-to-date returns (October 2018)
- Historical returns and diversification relative to peers, plus views on emerging market currencies (September 2018)
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. 1In Chapter 12 of “The General Theory of Employment, Interest and Money,” Keynes writes, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
2 Based on an equal-weighted portfolio of EM equity (MSCI EM Index), EAFE equity (MSCI EAFE Index), EM local bonds (JPMorgan GBI-EM Global Index), commodities (Bloomberg Commodity Index), U.S. high yield (Bloomberg Barclays U.S. Corporate High Yield Index), and REITs (FTSE NAREIT All Equity REIT).
3 We build our culture around core values of responsibility, curiosity, authenticity and collaboration. Not only do we actively seek to live and practice these values, we are also deliberate about minimizing the potentially destructive anti-values of blaming, committing to being right, withholding information and lacking trust in others.
4 For further insights, see “The Challenges of Diversity Investing” (2018), which I coauthored with Research Affiliates’ Jonathan Treussard and Lillian Wu.
5 See “Does the stock market fully value intangibles? Employee satisfaction and equity prices,” published 30 March 2011 in the Journal of Financial Economics. Edmans’ 2012 study, “The Link Between Job Satisfaction and Firm Value, With Implications for Corporate Social Responsibility,” showed similar findings.
6 Graham, John Robert, Jillian Grennan, Campbell R. Harvey, and Shivaram Rajgopal. 2018. “Corporate Culture: Evidence from the Field.” 27th Annual Conference on Financial Economics and Accounting Paper; Duke I&E Research Paper No. 2016-33; Columbia Business School Research Paper No. 16-49. Available at SSRN.