All Asset All Access

All Asset All Access, November 2017

In this issue, Research Affiliates examines the impact of correlations between mainstream and diversifying assets and discusses how the All Asset portfolios are positioning for geopolitical risks.

Christopher Brightman, CIO of Research Affiliates, discusses how the All Asset portfolios seek to offer investors the benefits of broad diversification and contrarian positioning despite a positive correlation to traditional 60/40 stock/bond portfolios, and Rob Arnott, founding chairman and head of Research Affiliates, offers insight into the ways the All Asset strategies may be able to help investors position for periods of market turbulence arising from geopolitical risk. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: What is your response to those who state that the All Asset strategies exhibit reasonably high positive correlations with mainstream portfolios, though you often refer to the strategies as contrarian?

Brightman: It’s true that portfolios consisting of risky capital market assets tend to display positive correlations with each other. It’s also true that negatively correlated positions, including shorts and hedges, are not designed to provide long-term return premiums; rather, such hedges incur costs.

Fortunately for investors, the benefit of diversification does not require a negative correlation, but only a correlation meaningfully below one. Spreading exposure across a breadth of asset classes offers the potential to improve a portfolio’s risk/return tradeoff. We have found that holding a widely diversified mix of asset classes can produce this benefit even if the assets themselves exhibit some degree of positive correlation to one another.

A straightforward correlation analysis across Morningstar’s database of global tactical asset allocation (GTAA) funds confirms the All Asset Fund’s diversification relative to its peers. During the 15 years since All Asset’s inception (on 31 July 2002), the average GTAA fund has exhibited a 93% correlation of monthly returns to a U.S. 60/40 portfolio (with 60% equities proxied by the S&P 500 and 40% bonds by the Bloomberg Barclays Aggregate Bond Index)! Nearly all these 268 supposedly diversifying funds are strongly anchored to the mainstream 60/40 portfolio.

The All Asset Fund is a positive outlier: Over the same span, its correlation level is within the lowest-third percentile, at just 70%. And as we might expect, the All Asset All Authority Fund’s average correlation to a U.S. 60/40 portfolio since inception (31 October 2003) is even lower – at 62% – given the fund’s ability to hedge U.S. equity risk.

These outcomes do not surprise us. Our mission with the All Asset strategies – and a core reason we launched this suite 15 years ago – is to serve as our clients’ source of real-return potential and diversification. Naturally, our strategies are designed to consistently emphasize real-return-oriented diversifiers with the prospect of delivering considerable value-add when mainstream markets suffer.

History demonstrates the benefits of emphasizing real-return-oriented diversifiers as the core of a complementary asset allocation approach to U.S. 60/40. Consider a hypothetical portfolio consisting of an equally weighted group of core Third Pillar markets, comprising commodities, long TIPS (Treasury Inflation-Protected Securities), REITs (real estate investment trusts), emerging market (EM) stocks and bonds, bank loans, and high yield bonds. Since 1973, this diversified portfolio would have delivered a modestly higher return (10.1% per year) than a U.S. 60/40 balanced portfolio (9.4%), with comparable risk, and also with a meaningful diversification benefit (as Figure 1 illustrates). And this opportunity to receive higher risk-adjusted returns was available even with average cross-correlation levels across these diversifying markets exceeding 40% over the past 20 years.1

Figure 1 features two graphs with plots of the annualized returns of Third Pillar assets (high yield, emerging markets, and real return) versus the S&P 500, U.S. core fixed income, and a 60/40 mix of stocks-to-bonds as of 30 September 2017. Proxies for all asset classes are listed below the figure. For both graphs, annualized returns are shown on the Y-axis. A graph on the left uses the X-axis to show volatility, while the one on the right uses it to show correlation to the S&P 500. On both graphs, Third Pillar is well placed, with annual returns of more than 10%, almost as much as the S&P 500, but with less volatility than the S&P 500, and less correlation to it. Third Pillar also beats out 60/40 mix in terms of performance and correlation to the S&P 500, and is only slightly more volatile. While Third Pillar has higher correlation to the S&P 500 and higher volatility than U.S. core fixed income, it has notably higher returns.

This vividly illustrates what Nobel Laureate Harry Markowitz, also a distinguished member of Research Affiliates’ Advisory Panel, called “the only free lunch in finance” – the notion that by diversifying, an investor can potentially receive a benefit (reduced risk) without a loss in returns.

It’s important to note that even if a mainstream and a diversifying investment exhibit occasional co-movement (i.e., positive correlation), the magnitude of such movements may vary considerably, meaning the assets will likely still have alternating outperformance cycles. This can make for a diversifying experience even if the overall correlation is positive. And whereas 60/40 portfolios have tended to outperform in strong equity bull markets – when diversification is least needed ­– Third Pillar assets have tended to snap back strongly and persistently after these periods.

Figure 2 helps illustrate this by showing the same return data from Figure 1 but on a calendar-year basis, which highlights the year-by-year relative return differences (i.e., the diversification) from a Third Pillar versus U.S. 60/40 approach despite their positive correlation to each other.

Figure 2 is a bar graph showing calendar year relative performance of 60/40 versus Third Pillar, from 1973 to 2017. Proxies for asset classes are shown below the figure. Third Pillar is shown to outperform relative to 60/40 in 28 of the 44 years, and is represented by blue bars rising above a horizontal line of zero. 60/40 outperforms 16 of the 44 years, shown by orange bars projecting downward, below zero. Overall, Third Pillar averages 10.1% per year, while 60/40 averages 9.4% per year.

As we look forward, the need for diversification appears more urgent than ever. While the past performance of mainstream U.S. stocks and bonds has been robust, it has also produced today’s meager yields. Fortunately, the wide dispersion of yields across global markets offers attractive opportunities for investors willing to go beyond those seemingly “safe haven” assets. Today, a broad array of Third Pillar asset classes (real assets, emerging markets and high yield bonds) are priced to potentially offer higher yields and better prospective returns, albeit with the potential for greater volatility.

Most investors scramble for diversifying strategies after experiencing the pain of a market crash, as in 2001 or 2009. Far fewer rotate into diversifiers before the need becomes self-evident, when diversification is more likely to be attractively priced. Courage is needed to put diversifiers in place during the late stages of a bull market, but history has shown that investors who do may ultimately be rewarded. We believe successful long-term investing requires us to embrace the truism that diversification is most valuable when it’s least wanted.

Q: How might geopolitical risks, including escalating tensions with North Korea, affect the All Asset funds, especially given your tactical emphasis on EM assets?

Arnott: Geopolitical disturbances create uncertainty and fear. And while this is uncomfortable for investors, we know that it’s possible to position for turbulence, and even potentially benefit from it. Historically, the All Asset Fund has added more value relative to 60/40 portfolios in volatile and down markets, as Figure 3 shows, and the All Authority Fund roughly doubles the diversification benefit when U.S. stocks are down (i.e., 10% invested in All Authority provided roughly as much diversification away from 60/40 as 20% in All Asset).

Figure 3 has an array of four bar graphs, showing how the All-Asset funds historically performed in low volatility and high-volatility markets, versus a 60/40 diversified portfolio, from fund inception through 30 September 2017. All Asset Fund and All Asset All Authority Funds outperformed 60/40 for both up and down high volatility markets. In a up high-volatility market, they outperformed by more than 500 basis points. In a down high volatility market, they displayed negative performance, but All Asset outperformed a 60/40 portfolio by almost 600 basis points, and All Asset All Authority by more than 1,200. In a down market with low volatility, the funds also outperformed. Only in an up low-volatility market did the All Asset funds trail a 60/40 fund, and even then had returns of at least 6% annualized returns. A table underneath the bar graphs contains detailed standardized performance data for the two funds for seven different trailing periods.

For the most recent quarter-end performance data for the All Asset and All Asset All Authority funds, please click on the links below:

While past may not be prologue, the All Asset strategies have tended to shine in markets that have often challenged mainstream balanced portfolios. As Figure 3 shows, the All Asset Fund has outperformed 60/40 portfolios by 7.85 percentage points (pp) in turbulent bull markets (upper right quadrant), 2.48 pp in low-volatility bear markets (lower left) and 5.85 pp in turbulent bear markets (lower right), which was dominated by the global financial crisis – and All Authority outperformed by roughly twice these levels in each bear market scenario. The All Asset and All Authority funds have underperformed, of course, when diversification is arguably least needed – in low-volatility bull markets – but not by a daunting margin.

The VIX (CBOE Volatility Index) has recently approached its lowest level ever, and overseas spreads have crashed to what we believe are truly unusual lows (see Figure 4, a version of which originally appeared on The result for us in managing the All Asset strategies has been to go risk-off in these newly rich markets and risk-on in markets that we believe still offer good opportunities. For example, European stocks remarkably now yield more than European high yield bonds, and they offer prospects for price appreciation if valuation multiples revert toward their historical norms; the bonds, on the other hand, offer little room for price appreciation.

Figure 4 is a line graph showing the effective yield of the Bank of America Merrill Lynch Euro High Yield index, and that of the U.S. 10-year Treasury, from 2006 through September 2017. European high yields are shown to have fallen over time to about 2.5% by September 2017, about the same level as those of U.S. Treasuries. The Euro High Yield was as high as 5% as recently as 2015, when the 10-year Treasury was around the same level as it is in September 2017. The effective yield on the Euro High Yield index peaked in late 2008 at 25%, and traded between 5% and 10% from 2009 to 2013.

The tensions in North Korea pose a remote but credible threat to geopolitical stability, and could affect emerging and developed markets alike. Many of our allies in the region find the status quo is not acceptable. But neither is war. At the moment, it seems that world leaders are testing whether a middle path – extreme isolation and confiscation of access to hard currencies – can rein in the most dangerous behavior. Let’s hope it can.

So what, outside the chilling threat to geopolitical stability posed by North Korea, might shock the markets enough to bring the current period of low volatility to end? The Wall Street Journal recently speculated on the possible ripple effects of a bitcoin (digital cryptocurrency) crash. And the end of quantitative easing in Europe, tightening monetary policy in the U.S., an unexpected surge in inflation anywhere, a severe earnings or revenue miss among the FANMAGs (Facebook, Amazon, Netflix, Microsoft, Apple and Google) – any of these known risks could jolt markets out of complacency.

We can’t predict whether or when shocks emanating from any of these areas will occur, or if they will be surprising enough – that is, far enough outside of current consensus expectations – to move markets. What we can predict – with some certainty – is that such a market-reversing shock, perhaps from a completely unexpected direction, will happen at some point.

And we can also say that, notwithstanding strong stock market returns for the past eight-plus years, future long-term returns will likely be much lower than past returns in developed economy sovereign bonds (especially non-U.S.), developed economy high yield bonds (especially non-U.S.) and stock markets trading above a Shiller P/E (price/earnings) ratio of 20 (yep, the U.S. is the shining example at roughly 30x, a top-decile valuation level). Moreover, we can say – with a high degree of confidence – that volatility will likely create opportunities for nimble investors and propel mean reversion of prices toward historical norms (rather than further away from them).

Finally, we are confident in how we have positioned the All Asset strategies to respond to market shocks, whether triggered by North Korea or some other exogenous event. The conventional response to uncertainty is to shun asset classes that have “tanked.” Those who only fear the risks, and fail to appreciate the valuation opportunity these risks create, will likely miss out. When market dislocations present what we believe to be bargains, we opportunistically average into the markets where we see the most attractive long-term return prospects.

As we’ve done for 15 years, we will continue to focus on what we believe to be our key competitive advantage: the ability to evaluate when long-term market prospects across a panoply of asset classes are severed from market perceptions, and then respond in a disciplined, patient and contrarian manner.

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:

  • A deep dive into the All Asset strategies’ dynamic risk positioning (October 2017)
  • A retrospective look at the All Asset Fund’s performance in the 15 years since its launch (September 2017)
  • Outlook for inflation and real return investing (August 2017)
  • Outlook for credit markets, plus a framework for creating long-term asset class forecasts (July 2017)
  • The case for diversification amid an aging bull market for U.S. stocks (June 2017)
  • Continued opportunities in emerging markets (May 2017)
1 We analyzed cross-correlation levels over past 20 years instead of since 1973 because the former is the earliest common time period across all six asset classes, proxied as follows: U.S. high yield (Bloomberg Barclays U.S. Corporate High Yield Index), long U.S. TIPS (Bloomberg Barclays U.S. Treasury Inflation Notes: 10+ Year Index), EM local bonds (JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged)), EM equities (MSCI EM Index), REITs (Dow Jones Select U.S. REITs Index) and diversified commodities (Bloomberg Commodity TR Index).
The Author

Chris Brightman

Chief Executive Officer and Chief Investment Officer, Research Affiliates

Robert Arnott

Founder and Chairman, Research Affiliates

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