All Asset All Access

All Asset All Access, October 2017

In this issue, Research Affiliates discusses where it sees opportunity for attractive long-term returns and offers insight into the All Asset strategies’ dynamic risk positioning.

Rob Arnott, founding chairman and head of Research Affiliates, discusses why taking advantage of current low prices on global value stocks may position the All Asset portfolios for attractive long-term returns, while Michael Aked, Research Affiliates’ head of asset allocation, provides insight into the All Asset strategies’ dynamic approach to risk assessment and positioning. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: In your view, what is the most compelling opportunity for attractive potential long-term returns within the All Asset suite?

Arnott: In 40 years of investing, I’ve seen that exceptional opportunities tend to share a few common attributes. True bargains – opportunities with promising long-term return prospects – are usually loathed or feared by investors, often because they believe that things could easily get worse before they get better. This means that while exploiting such opportunities is possible, it requires courage and patience, both of which tend to be in short supply when it comes to investing.   

To gain maximum exposure at the lows, we must have the courage to buy more as prices fall and fears grow. We must routinely accept short-term pain in order to position the portfolio for meaningful longer-term gain potential. Realizing fair value then takes time, often many years. But deliberately embracing this type of trade-off is central to why we’ve been able to fulfill our mission to clients over the past 15 years.1

Today, we find that prices on value stocks across a panoply of markets – and especially within international and emerging markets – are true opportunities. Growth has outpaced value by roughly 1,000 basis points globally this year to date, a huge shortfall for value investors in just nine months (when looking at the cumulative return difference between the MSCI World Growth and MSCI World Value indexes through August). The outperformance of growth stocks over value stocks in 2017 to date ranges from 6% in EAFE (Europe, Australasia and Far East) to 14% in the U.S. and emerging markets (as measured by the MSCI EAFE Value, MSCI EAFE Growth, Russell 1000 Value, Russell 1000 Growth, MSCI EM Value and MSCI EM Growth indexes). Call it the triumph of the FANMAGs.2 

While value investing has experienced long spans in purgatory, it has been a reliable source of modest excess returns over growth stocks in the long run. 3 Across all rolling 10-year outcomes since 1975, global value stocks on average have beaten their growth counterparts more than 80% of the time, translating into average outperformance of 2.0% per year (when looking at the average rolling 10-year excess return of MSCI World Value over MSCI World Growth from January 1975 through August 2017). 

Nonetheless, over the past 10 years (through August), growth beat value globally by over 200 basis points per year, nearly eclipsing the record set during the tech bubble! And in the U.S., growth’s outperformance was even stronger, at nearly 350 basis points per year. So is value permanently impaired, or is it just newly “cheap”? Value managers and their clients have been wringing their hands, asking “When will the pain end?”

History gives us no useful answer to the “When” question, but there is a silver lining – and my, how it has shined! When value has underperformed, it’s because value was getting “cheaper.” And value exhibits a powerful tendency toward mean reversion: When the spring is coiled this tightly, the subsequent rebound can potentially be impressive and lasting. 

Just as value experienced a decade-long bear market relative to growth, it has also enjoyed extended bull runs. As the gap between value and growth stretches further, it increasingly sets the stage for potential prolonged outperformance. So, like the value managers, we’re also rubbing our hands – but in anticipation! If this were a film, we know what the next scene should look like (we’ve seen it before) – we just don’t know exactly when it will begin.

How do the All Asset strategies seek to capture today’s compelling opportunity in value stocks? One key way is through their exposure to the PIMCO RAE strategies, which are designed to harness the benefits of a rules-based value approach while incorporating research insights on smart beta, return premia, risk diversification and implementation. As of 30 June 2017, our allocation to the RAE suite of strategies was 28.4% in All Asset and 31.8% in All Authority. 

The RAE strategies employ a dynamic rebalancing process that increases exposure to value when value is out of favor (and “cheap”) and reduces exposure when value is “rich.” By design, these strategies are positioned to have maximum value exposure when value turns. In this way, we believe the RAE approach harnesses a value premium more efficiently than traditional value approaches. Wind the film back a few years. These strategies were trading very cheap relative to the market – everywhere – at the start of 2015.  This set the stage for the strong results of 2016.

With value again underperforming in 2017, how has RAE responded? By taking on an even deeper value tilt than it had before the 2016 surge! From this level of “cheapness,” we may not have terribly long to wait for value to rebound and perhaps usher in a lengthier bull market. Value stocks are trading anywhere from moderately “cheap” (in the U.S.) to record “cheap” (in emerging markets); while the market has been on a massive growth binge, the RAE strategies have steadily taken a more aggressive value stance. And even if I’ve seen it before, I can’t wait for the next scene in this film! 

Q: How does Research Affiliates dynamically adjust the “risk dial” within the All Asset portfolios?

Aked: Since their launch, the All Asset strategies have relied on a disciplined contra-trading methodology that responds to market movements and adjusts its prospective risk levels. That is, we gauge when risk-taking is most likely to be rewarded and adjust our proverbial “risk dial” to reflect the best long-term risk-to-reward opportunities across a wide set of asset classes. When assets are “cheap” and economic growth trends look favorable, our strategies are more likely to adopt a risk-on, return-seeking stance. Conversely, when risk premiums are skinny and economic uncertainty predominates, we’re more likely to dial back risk and move to a more conservative, defensive posture.

A deeper dive into how we assess risk-taking and determine when it is most likely to be rewarded may shed some light on the process underlying the All Asset strategies’ dynamic risk profile.

One way to assess risk is to observe the incremental expected return per unit of risk – or the slope of an expected Sharpe ratio – offered by the market over time. To estimate this, recall that starting real yields have historically been a strong predictor of future returns. By coupling yields with a growth estimate and using forward-looking risk estimates, we derive an average estimated Sharpe ratio across all asset classes available to the All Asset suite. As the chart shows, this measure has varied widely, plunging to -5% at the tech bubble’s peak and soaring to more than 20% during the financial crisis. 

Varying market prices and yields offer opportunities for strategies that systematically and flexibly adjust their risk postures over time. By design, the All Asset strategies explicitly move toward a more risk-on stance when markets are more likely to reward us for taking on that risk – in other words, when the market’s expected Sharpe ratio is steeper. The reverse is also true.

Recently, the average Sharpe ratio for all asset classes4 has been falling due to higher market prices, resulting in lower market yields and future expected returns. As such, we have been reducing our risk exposure. If asset prices continue to move higher, we’d expect our portfolios to keep incrementally dialing back market risk and adopt an increasingly defensive posture.

The figure is a line graph showing the average risk compensation as measured by Sharpe ratios across 15 asset classes, over the period 1980 to 2017. The figure was down to about 0.05 in 2017 from about 0.23 in 2009. Over time, the graph shows the figure fluctuating between a low of negative 0.07 in the late 1990s, and a high of 0.23 in 2009. In 2017, the figure is about 0.06, near a decade low of 0.05. Notes and definitions are listed below the chart.

Observant readers may also note the short-term persistence of directional trends in the Sharpe ratios shown in the chart. In other words, when markets are “cheap” (or “rich”), they tend to remain that way over multiple months (and occasionally even years). A simple measure of persistence – the correlation of Sharpe ratios from one month to the next, as shown in the chart – clocks in at a near-perfect 0.975. This persistence is often referred to as momentum, or the tendency for abnormal market movements to continue over the very short term (measured in months). But over longer time spans, this relationship decays. 

How do we address the short-term effects of momentum while seeking to take advantage of mean reversion, which inherently requires time and patience? One way is by slowing the contra-trading process, trading patiently and deliberately. Returns from momentum are often difficult to harvest, given the high costs involved with frequent trading. Pacing our entry into and exit out of asset classes allows us to both lower turnover and increase the return potential of our strategies.

This does not mean we are abandoning our core value-based investment approach, which is premised on longer-horizon mean reversion of asset prices. Rather, this reflects a refinement of our value-based approach to better account for empirically observed momentum, which also has an effect over shorter horizons.

As our readers are well aware (and as our name suggests), we are continually pursuing various research endeavors. We look forward to sharing our findings with you as we gain further insight into how best to harness the return potential of momentum.

Further reading

Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:

  • 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)
  • Benefits of active investment management in Third Pillar assets (April 2017)

1 Our mission is threefold. Anchored by a disciplined, contrarian, value-oriented approach, we strive to improve long-term real returns, offer diversification away from mainstream asset classes and provide a reliable source of real return potential.

2 Facebook, Amazon, Netflix, Microsoft, Apple and Google. And we might well add Samsung, Tencent, Tesla and an array of others. Gosh, is Tesla really worth $800,000 per car it produced last year, against $6,000 per car for Ford? Sure, if autos are 100% electric in 20 years, and if they’re all made by Tesla!

3 Both empirical data and theory show that value tends to outperform growth in the long run. We believe investors have preferences broader than risk and return (e.g., for comfort, familiarity, good news), which makes them predisposed to price growth stocks at a level that will deliver a smaller return, and value stocks at a level that will reward their discomfort. This results in a value anomaly.

4 We should note that the average asset class Sharpe ratio is exactly that: the average of all asset classes. When we build portfolios on the efficient frontier, we allow ourselves to be very selective about the particular assets we buy, and at what weights. As a direct result, our portfolios will have a different and necessarily higher Sharpe ratio.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

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Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative or by visiting Please read them carefully before you invest or send money.

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

Past performance is not a guarantee or a reliable indicator of future results.

A word about risk:

The fund invests in other PIMCO funds and performance is subject to underlying investment weightings which will vary. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.  Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors.  Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies.  Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested.  The cost of investing in the Fund will generally be higher than the cost of investing in a fund that invests directly in individual stocks and bonds.  Diversification does not ensure against loss.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

The analysis conducted in the provided chart involves hypothetical modeling. Hypothetical or simulated performance modeling techniques have inherent limitations. These techniques do not predict future actual performance and are limited by assumptions that future market events will behave similarly to historical time periods or theoretical models.  Future events very often occur to causal relationships not anticipated by such models, and it should be expected that sharp differences will often occur between the results of these models and actual investment results. Simulated risk analysis contains inherent limitations and is generally prepared with the benefit of hindsight. Realized losses may be larger than predicted by a given model due to additional factors that cannot be accurately forecasted or incorporated into a model based on historical or assumed data.

References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.

The Morgan Stanley Capital International (“MSCI”) Europe, Australasia, Far East Growth Index ("EAFE Growth ") is an unmanaged index consisting of that 50% of the MSCI EAFE with the highest Price/Book Value (P/BV) ratio.  Index weightings represent the relative capitalizations of the major overseas markets included in the index on a U.S. dollar adjusted basis.  The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. The Morgan Stanley Capital International (“MSCI”) Europe, Australasia, Far East Value Index ("EAFE Value") is an unmanaged index consisting of that 50% of the MSCI EAFE with the lowest Price/Book Value (P/BV) ratio.  Index weightings represent the relative capitalizations of the major overseas markets included in the index on a U.S. dollar adjusted basis.  The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. The MSCI Emerging Markets Growth Index captures large and mid cap securities exhibiting overall growth style characteristics across 24 Emerging Markets (EM) countries*. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend. The MSCI Emerging Markets Value Index captures large and mid cap securities exhibiting overall value style characteristics across 24 Emerging Markets (EM) countries*. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield. The Morgan Stanley Capital International (“MSCI”) World Growth Index is an unmanaged index consisting of that 50% of the MSCI World Index with the highest Price/Book Value (P/BV) ratio.  Index weightings represent the relative capitalizations of the major overseas markets included in the index on a U.S. dollar adjusted basis.  It is not possible to invest directly in an unmanaged index. The Morgan Stanley Capital International (“MSCI”) World Value Index is an unmanaged index consisting of that 50% of the MSCI World Index with the lowest Price/Book Value (P/BV) ratio.  Index weightings represent the relative capitalizations of the major overseas markets included in the index on a U.S. dollar adjusted basis.  Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.  It is not possible to invest directly in an unmanaged index.

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