Research Affiliates’ Rob Arnott, founding chairman, provides an overview of the fund’s performance history since inception; Research Affiliates CIO Chris Brightman discusses All Asset as a diversifying return driver; and John Cavalieri, PIMCO asset allocation strategist, looks at what differentiates the All Asset strategies from other global asset allocation approaches. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: As the All Asset strategy crosses its 15th anniversary, what are your reflections on the journey?

Arnott: Let’s wind the tape back. In 2000, we had just experienced a stupendous quarter-century bull market, the last 18 years of it further propelled by a collapse in inflation. Classic 60/40 balanced investing (that is, 60% in U.S. stocks, proxied by the S&P 500, and 40% in U.S. core bonds, proxied by what we now know as the Bloomberg Barclays U.S. Aggregate Bond Index, called the Lehman Aggregate back in the day) had delivered 14% compound annual returns since 1975. And off a low in August 1982 (following a double-dip bear market starting in 1980) to the August 2000 highs, the passive 60/40 portfolio earned a remarkably high 16.8% annual return, beating inflation by more than 13% per year. How big was disinflation’s role in these returns? Huge: Disinflation allowed yields to tumble – stock yields fell from 6% to 1%, while bond yields fell from the mid-teens to around 6% – and tumbling yields delivered capital gains on top of lofty starting yields. Voila! The largest bull market in U.S. history.¹

In 2000, many investors, anchoring their thinking largely on this history, expected more of the same. We at Research Affiliates did not. In February 2000 I coauthored a paper with Ron Ryan (subsequently published in the Journal of Portfolio Management in 2001) titled “The Death of the Risk Premium.” In it we pointed out that the tumbling of stock market yields, paired with 4% yields on long U.S. Treasury Inflation-Protected Securities (TIPS), made it near-certain that from their lofty heights, stocks would deliver a lower long-term return than bonds for long-term investors.² Now, 17 years into the new century and since weathering the global financial crisis, stocks (i.e., S&P 500) have experienced the second-longest bull market in 200 years of U.S. stock market history³ – yet they’ve delivered a scant 5% annualized since 2000, while long U.S. government bonds (proxied by the Barclays U.S. Treasury Long Index) have delivered nearly 7% with less risk, and the Barclays U.S. Aggregate Bond Index has exceeded 6%.

For data and methodology underpinning the analysis of long-term U.S. stock and bond market history, please see “The Death of the Risk Premium,” by Rob Arnott and Ronald J. Ryan, first published as a First Quadrant monograph in February 2000, and later published in the Journal of Portfolio Management in Spring 2001; see also “The Biggest Urban Legend in Finance” by Rob Arnott, published by Research Affiliates in March 2011. In these papers, historical market data prior to inception of the S&P 500 Index and the Bloomberg Barclays U.S. Aggregate Bond Index is sourced to Ibbotson Associates, the Cowles Commission and other research.

We pointed out that the risk premium could, like the Phoenix, rise from the ashes if yields flipped, so that stock yields were higher than TIPS yields – as they are today. A positive risk premium, it bears notice, does not mean a return to lofty returns. It can mean low returns for both stocks and bonds, as are on offer in today’s markets.

In any event, in 2000 – and even more urgently today – investors faced three challenges that weren’t being addressed: the likelihood of low prospective returns on mainstream stocks and bonds, a lack of true diversification in conventional balanced portfolios and a vulnerability to inflation. If disinflation, paired with high starting yields, could fuel the largest bull market in history, then the reverse might also be true: Renewed inflation, paired with low starting yields, could deliver one of the bleakest markets in history. So in 2000, when PIMCO’s Brent Harris approached us about launching a remarkable new strategy to tackle these very issues, we readily accepted the challenge!

Our shared goal was to create a real-return-centric, contrarian strategy that

1. Seeks to improve investors’ long-term real returns, particularly when low yields on mainstream stocks and bonds are unlikely to produce the rates of return required to achieve their long-term needs,
2. Diversifies our clients away from the U.S.-centric equity risk that dominates many investors’ portfolios, and
3. Helps counter one of investors’ biggest threats, renewed inflation, which pushes yields higher on their mainstream investments.

We believed that no product was then available to address all three needs in a single package. So we created one. We named the strategy All Asset, because we deliberately invest in a wide roster of asset classes, seeking those that are correlated with inflation while offering potential for high yield, high growth or both. Then and now, no other fund family we’re aware of spanned as many asset classes and could deliver as broad a real return toolkit as the All Asset Fund.

Over this 15-year journey, we’ve experienced two massive bull markets sandwiching the most severe global bear market since the 1930s. And though we have yet to see the dramatic reflation that we’re positioned to help investors address, at current prices and yields we’re actually currently being compensated for holding inflation-related assets while we wait!

This latest market cycle – in particular the 2013–2015 stretch in which U.S. stocks meaningfully outpaced most asset classes – has been grueling for active managers, as any active positioning away from U.S. stocks almost assuredly detracted from value. But a diversifying strategy needs a full market cycle to prove its worth. Case in point: Of all global asset allocation funds existing as of 31 July 2002, nearly half are now gone (260 of 529).⁴ And how many of the survivors – many of which, in our view, fail to offer much in the way of diversification relative to an investor’s core balanced holdings (a core purpose of such funds!) have added value versus their benchmarks over the past 15 years? A mere 30%. The average excess return over this full span has been a disappointing −0.72% per year.

As we look back at the last decade and a half, has the All Asset Fund fulfilled its mission to our clients? We believe we have, in all three dimensions, and wholly consonant with our goals.

First, since its launch, All Asset has delivered an annualized net-of-fees return of 7.20%, outpacing the Bloomberg Barclays U.S. TIPS (1-10 Year) Index (its primary benchmark) by 308 basis points, while modestly exceeding our secondary benchmark of Consumer Price Index (CPI) + 5%. (See Figure 1.) Check! Have there been times when we fell short? Of course. Our strategic home base asset classes of real assets, emerging markets and high yield bonds – what we’ve referred to as the Third Pillar – aren’t immune from periodic bear markets. But we can seek to reduce downside exposure, and our disciplined, contrarian process compels us to increase exposure at those lower prices, enabling the potential for a relatively fast snap back and, for the patient investor, a result that has been in line with our secondary benchmark, which we believe better reflects the long-term objectives of the Fund.

For the most recent quarter-end performance data for the All Asset fund, please click on the link below:

• PIMCO All Asset Fund

Second, has the All Asset Fund served as a diversifier away from mainstream stocks and bonds? Check! Being a diversifier – and staying the course with diversifying assets – is far easier said than done. One of my colleagues, Jason Hsu, has described diversification as a “regret-maximizing” strategy. In a raging bull market, we regret having any diversifiers; let’s not forget 2013–2015, when 60/40 portfolios were enjoying a bull market, while Third Pillar diversifiers (real assets, emerging markets and high yield bonds) were in a bear market! And in a bear market for mainstream assets, we regret not having far more diversifiers in our portfolio. Now, in the ninth year of a protracted U.S. equity bull market, do investors need their diversifiers? We say, yes.

Many global tactical asset allocation (GTAA) funds claim to offer good diversification, but on closer inspection, they offer a strong dose of U.S. equity exposure. When we survey the aforementioned funds with a 15-year track record in the Morningstar Allocation categories, the average equity beta to the S&P 500 over the full span was 0.66, which is even higher than a conventional 60/40 mix! In stark contrast, the All Asset Fund’s average exposure to U.S. equity risk, as reflected in an equity beta of just 0.39, is in the bottom 6th percentile in this universe. But it’s no surprise that our equity beta is so different: It’s what we do.

And third, has our strategy exhibited a real return orientation? Check! A strategy’s reaction to changes in inflation expectations provides an effective means for assessing its ability to protect against inflation. Isn’t it preferable for a strategy to be correlated with inflation surprises (i.e., changes in expectations), rather than with the known level of expected inflation? Since its launch, the relationship of the All Asset Fund’s returns to changes in 10-year breakeven inflation (see Figure 2) has been significant, as reflected by a correlation of 84%. When inflation expectations are rising, All Asset has tended to do well. Our deliberate focus on a wide roster of both traditional and “stealth” inflation fighters is a big reason.

I’m often shocked that there are so few real return–oriented, diversifying solutions in the marketplace. Then again, these strategies are often at odds with “the pack” – especially during the late stages of an equity bull market – and may test the patience of even the most disciplined and steadfast investors. Diversifiers, by definition, will sometimes go up at the same time that core holdings falter, and vice versa, as we saw in 2013–2015. In today’s low yield world, with central bankers worldwide striving mightily to ignite inflation, I believe investment success requires a healthy allocation to a strategy that seeks to diversify risk and counteract mainstream investments’ vulnerability to inflation while providing attractive immediate yield and meaningful long-term forward-looking return potential. We believe the rationale for investing in All Asset is as compelling and relevant as ever in our 15-year history.

I want to thank you for your confidence and for joining me on this journey. I look forward to the next 15 years!

Q: Why should investors consider the All Asset funds as their diversifying return driver over the coming cycle?

Brightman: We think now is an opportune time to diversify away from mainstream assets to exploit attractive relative valuations and position for improved potential long-term real returns. Real return–oriented diversifiers become increasingly important when mainstream investments are priced to offer inadequate real returns. And real return–oriented diversifiers are even more attractive when inflation is not yet a self-evident risk, so inflation hedges are relatively cheap. We see evidence of both circumstances today.

Consider current market conditions. We are in the ninth year of a sustained U.S. equity bull market – the second-longest bull market of the past 200 years. While no one has the clairvoyance to accurately and consistently identify market turns, a variety of common valuation metrics suggest that mainstream markets are priced to offer negligible prospective long-term real returns.

The starting earnings yield of the S&P 500, defined as the ratio of 10-year trailing real earnings per share divided by current price, has plunged to a historical low, falling into the bottom third percentile for the past 200 years.⁵ The prospects are also bleak across conventional bonds. The yield of the Bloomberg Barclays U.S. Aggregate Bond Index was 2.5% at the end of July, which puts it within its lowest historical decile since 1800. ⁶

Recall the strong historical relationship between starting yields and long-term prospective returns.⁷ While past results are never a guarantee of future results, if we use history as a guide, today’s low yields and high valuation multiples suggest bleak long-term return prospects across mainstream domestic stocks and bonds.

In contrast, Third Pillar markets still offer compelling opportunities, even after recent positive price momentum. For instance, consider the current yields of the following markets as of 31 July 2017: 4.1% for REITs, 5.4% for U.S. high yield bonds and 6.1% for EM local bonds (proxied by the FTSE NAREIT All Equity REIT Index, the Barclays U.S. Corporate High Yield Index and the J.P. Morgan GBI-EM Index, respectively). These markets trade at attractive discounts, especially relative to the conventional 60/40 portfolio, which exhibits a yield of just 2.2%.

The All Asset strategy is designed to further emphasize what we view as the cheapest, most attractive markets. Because markets tend to ultimately mean revert,⁸ contra-trading against markets frequently pays off for the patient investor. We expect investors to benefit from opportunistic positioning into higher-yielding asset classes over the coming cycle, just as they have over the last.

The All Asset strategy is also designed to exhibit high correlation with inflation surprises by favoring inflation-sensitive assets, in an effort to preserve investors’ real purchasing power. As of 31 July 2017, inflation expectations – as measured by the U.S. 10-year breakeven inflation rate of 1.8% – fell within the lowest quartile of all historical observations since the launch of the All Asset strategy 15 years ago. When inflation expectations are low, inflation-sensitive assets naturally tend to be cheaper.

Of course, valuation isn’t a tool for short-term market timing. Rather than guess when markets will turn, we prefer to have our diversification in place, to serve as defense when mainstream investments struggle.

We have conviction that the All Asset strategy can continue to successfully deliver on its long-term mission – to benefit investor portfolios by serving as their real return–oriented, diversifying return driver. Our disciplined, contra-trading process of continually rebalancing across a vast span of markets is key to harvesting incremental return over the long run. In addition to this key source of long-term value added, our strategy is also designed to access the alpha potential from PIMCO’s high-performance suite of actively managed funds. We believe these sources will continue to provide excess return potential for the benefit of our patient investors, just as they have over the last 15 years.

Q: From the PIMCO perspective, what makes the All Asset strategies unique?

Cavalieri: Over the last 15 years, the All Asset strategies have favorably distinguished themselves within the mutual fund marketplace for having delivered a much sought-after “trifecta” for investors: 1) attractive long-term returns, 2) diversification away from U.S. equity risk and 3) a potential counter against rising inflation. That is why the All Asset Fund and its sister strategies have grown to be a nearly $30 billion complex as of 30 June 2017.

Beyond that important bottom line, from PIMCO’s perspective there are two elements that really make All Asset unique: the differentiated asset allocation style and the partnership approach used in managing the Fund, both of which are geared to enhance returns and manage risks for investors.

First, regarding its differentiated asset allocation style, we believe All Asset remains an innovative outlier within the broad asset allocation category. Recall that PIMCO has long been an innovator in real return investing. In January 1997, we launched the first dedicated TIPS (U.S. Treasury Inflation-Protected Securities) mutual fund, the PIMCO Real Return Fund, on the same day the U.S. Treasury auctioned the first TIPS bond. In June 2002, we launched our first dedicated commodities fund, the PIMCO CommodityRealReturn Strategy Fund, with an innovative Double Real^® approach,⁹ which grew to be one of the largest mutual funds of its kind. And in July 2002, partnering with Research Affiliates, we launched the PIMCO All Asset Fund, a unique multi-asset strategy with an explicit real return objective and a secondary benchmark of CPI+5% – both of which represent a far departure from the equity-centric “balanced funds” that continue to dominate the asset allocation category.

To appreciate this differentiation, we evaluated the risk composition of the 10 largest asset allocation funds in the Morningstar World Allocation and Tactical Allocation categories, the latter of which includes All Asset (see Figure 3). The difference in results is stark. While the absolute level of risk is comparable across the top 10 funds, between 7%–8% on average, the composition of that risk is very different. Excluding All Asset, the top ten asset allocation funds derive the overwhelming majority of their total risk from equities, 83% on average. By contrast, the same figure for All Asset is just 29%! So All Asset is both living up to its name – sourcing return and risk from a wide variety of global asset classes – and also employing a highly differentiated allocation approach that results in measurably different risk and correlation statistics. All Asset is not your conventional GTAA (global tactical asset allocation) strategy … and that is by design.

Second, the partnership approach in managing the All Asset Fund was a novel one for PIMCO in that it provided investors with two independent engines of value-added potential. In managing the fund, there is a clear division of labor. Research Affiliates, the firm founded by Rob Arnott, serves as the sub-advisor responsible for the asset allocation decisions. Rob, Chris and their deep and impressive team employ a research-intensive, model-driven process that embeds the contrarian, value-oriented approach that has been a hallmark of Rob’s distinguished investing career. But instead of implementing those allocation views across passive instruments or ETFs, investors in the All Asset strategies benefit from a second source of return potential. Underlying exposures are obtained through actively managed PIMCO funds, over 50 in total, providing exposure to a full toolkit of global asset classes and strategies, and also incremental return potential since each fund is managed by a PIMCO portfolio management team seeking to outperform that fund’s benchmark, net of all fees and expenses.

And the combined results have been impressive. When we compare All Asset’s net-of-fee returns not only to its benchmarks but to two “do it yourself” proxies – an equally weighted mix of three real assets (TIPS, commodities and REITs) and an equally weighted mix of six Third Pillar assets (TIPS, commodities, REITs, EM stocks, EM bonds and high yield) – the All Asset Fund comes out ahead on each of the key return and risk metrics (see Figure 4). Of course, if hypothetical management fees were added to these two multi-index proxies, the advantage for All Asset would be even greater.

In summary, we believe All Asset remains a unique and favorably differentiated strategy. But being unique just for uniqueness’s sake is of little value. Fortunately, our differentiation is an intentional result of our focus on addressing three key investor needs – long-term return, diversification and inflation protection. After 15 years, we are pleased to report that these efforts have resulted in a measurable value proposition to our clients, and we believe we remain well-positioned to continue doing the same for many years to come.

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:

• 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)
• Where conventional wisdom may be making mistakes in today’s market (March 2017)