Rob Arnott, founder and chairman of Research Affiliates, discusses how the All Asset strategies seek to avoid asset class bubbles while potentially benefiting from “anti-bubbles,” while Jim Masturzo, head of asset allocation at Research Affiliates, discusses what is driving net yields for the All Asset strategies relative to mainstream stocks and bonds. John Cavalieri, asset allocation strategist for PIMCO, explains the rationale for the upcoming change to the primary benchmark for All Asset All Authority. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: How are the All Asset strategies positioned to take advantage of opportunities when so many markets have historically low yields and high valuations – what many are calling ‘bubbles’?
Arnott: Before we turn to the opportunities that the All Asset strategies seek to capture, let’s first define “bubble.” We define a bubble as having two characteristics. First, we view the asset or market as expensive relative to its potential future growth and income, such that it has little chance of delivering better future returns (a “risk premium”) relative to U.S. government bonds or cash. This can be gauged using a generally accepted valuation model, like a discounted cash flow model, with a plausible projection of future cash flows. Second, the marginal buyer of the asset or asset class in a bubble appears to have little interest in valuation models, presumably buying based on a popular narrative and expecting to resell the asset to someone else at a higher future price. And apparently hoping the market will signal when it’s time to sell!
In recent publications1 we have explored both bubbles and the “anti-bubbles” we see in certain markets today. We define an anti-bubble as effectively the opposite of a bubble. It is a market that requires what we view as implausibly pessimistic assumptions in order not to beat bonds and cash when using a standard valuation model. In addition, in an anti-bubble, the marginal seller appears to have no interest in valuation models, which may be indicating the asset is undervalued.
We believe these definitions can help in seeking to identify a bubble or anti-bubble in real time, instead of years after the fact.
It bears mention that while an individual stock (or other asset) can be a bubble, an individual asset generally cannot be an anti-bubble; almost any single asset can go to zero. Furthermore, bubbles continue to reward investors – and anti-bubbles continue to punish investors – until the bubble or anti-bubble bursts. This is why we think averaging into the anti-bubble stocks (and out of the bubble stocks) is so important: Make too large a bet too soon, and you can get hurt.
So, how do the All Asset strategies seek to avoid the trap of current bubbles and instead seek out anti-bubbles and assets that are likely undervalued? The key is that the All Asset strategies are designed to 1) systematically shift an investor’s exposure away from bubble assets (which admittedly could mean missing late-stage trending markets, even though that may be akin to picking up nickels in front of a steamroller); 2) diversify across investments that we believe are not in bubble territory; and 3) seek out anti-bubble opportunities. A disciplined contrarian, value-oriented trading approach is at the heart of this investment process, which averages out of the expensive, beloved markets and into inexpensive, out-of-favor markets – uncomfortable trades that go against most investors’ evolutionary wiring to follow trends.
As we look across global asset classes, emerging markets – most notably unloved emerging market (EM) value stocks and state-owned enterprises – fall squarely within our anti-bubble camp. As of 31 July 2019, allocations to EM asset classes amounted to 38.7% in the All Asset strategy and 45.0% in the All Authority strategy.2 While emerging markets as a whole currently trade at much more attractive valuations than the U.S. markets, value strategies within emerging markets are even cheaper, with the gap between growth and value in record territory (as proxied by the MSCI Emerging Market Growth and Value indices). Our models indicate that EM value stocks have potential to deliver an additional performance advantage over their broader cap-weighted market benchmarks over the next decade.
Along with seeking anti-bubbles in the EM arena, the All Asset approach aims to reduce investors’ exposure to bubbles in equities by largely avoiding cap-weighted index exposures, especially late in market cycles. Instead, the All Asset funds allocate to a range of PIMCO equity funds that are based on the Research Affiliates’ Fundamental Equity strategy, which seeks to sever the link between stock price and portfolio weights by systematically rebalancing to portfolio weights that are based on measures of fundamental business scale. As of 31 July 2019, total allocations to this family of funds are 39.1% in All Asset and 48.3% in All Authority.3
Lastly, we reiterate that the trajectory of a bubble or an anti-bubble (and the conditions underlying it) will, by its nature, continue until it turns. Without this expectation, the bubble would collapse immediately. Our approach of systematically dollar-cost averaging into our positions is designed to harvest incremental return over the long term. A disciplined process that continually tilts away from markets that appear overvalued and into markets that may be unjustifiably deemed cheap may potentially reward those who are steadfast, patient, and willing to accept some short-horizon maverick risk. We aim to position our investors to benefit when the anti-bubble eventually turns, or the bubble inevitably bursts.
Q: What are the key drivers of the All Asset funds’ net yields?
Masturzo: Let’s begin with some context: namely, how the yields of mainstream assets have trended this year, and why an understanding of yield levels matters for investors.
A central market theme of 2019 has been the continuing pullback in interest rates, with the U.S. 10-year Treasury yield closing the second quarter at around 2% and falling further from there. Equity yields have been no better, with the S&P 500 dividend yield coming in at 1.9% for the second quarter (according to Bloomberg), or a bit higher if share buybacks are considered, but still lower than the long-term historical average. The low yields are largely a result of the strong and extended bull market in mainstream assets, in which prices have grown faster than cash flows.
This context matters when looking ahead because yield is an essential component in any model of expected return. To illustrate the point, consider a very simple and purely hypothetical asset: a default-free zero-coupon bond, held to maturity. For this asset, its yield is both its expected return today and also, by definition, its realized return to maturity in the future. While other assets or portfolios of assets may have more complex dynamics, yield is still an essential ingredient in the expected return. With this in mind, it makes sense to look at the yield of the All Asset funds, as well as to understand the current contributors to that yield.
As with many things in finance, not everyone agrees on a single definition of yield. For regulatory purposes, PIMCO cites two types of yield for each of its funds – distribution yield and SEC yield4 – each with its own underlying assumptions. As Figure 1 shows, despite differences in how these yields are defined, their values have been similar in most periods for the All Asset funds.
The distribution yield in both funds has been rising since 2016 and is currently (as of 30 June 2019) 4.83% for All Asset Fund and 5.15% for All Asset All Authority Fund. In fact, with only a few exceptions (10.4% of the time for All Asset Fund and 9.6% of the time for All Asset All Authority Fund), both All Asset funds have maintained a distribution yield above 4% for their monthly reporting periods over the last 16 and 15 years, respectively. Although yields in the past few years have been lower than in early periods for these strategies, this trend is in line with reduced yields for most major asset classes.
For the most recent quarter-end performance data for the All Asset and All Asset All Authority funds, please click on the links below:
Click for All Asset Fund prospectus and All Asset All Authority Fund prospectus.
These yield levels are largely a result of the structural orientation of the funds. The All Asset model underlying the strategies is based on a series of expected returns of which yield is a core building block. The funds’ disciplined investment process and orientation toward diversifying “Third Pillar” assets mean that EM stocks and bonds, absolute return strategies, high yield bonds, and real return strategies have been key sources of yield.
Moreover, many of the underlying PIMCO funds that we use employ a “PLUS” strategy, which seeks to provide capital-efficient, two-in-one yield-enhancing potential within a single fund. For example, a fund might aim to provide exposure to a primary asset class, such as equities or commodities, through the use of futures contracts or total return swaps, and also fully collateralize those positions with high quality fixed income. We believe this is a capital-efficient approach to seeking a structurally higher yield in a risk-prudent manner, while still limiting tracking error to the underlying fund’s primary benchmark.
Also, our emphasis on RAE equity strategies (versus market cap-weighted equity strategies) offers an additional potential yield premium, given the value orientation of RAE.
Finally, our ability to invest across a range of PIMCO’s more liquid absolute-return strategies as an alternative source of low-beta “dry powder” can also offer potential yield enhancement when used in lieu of traditional dry-power allocations, such as short-term and core bond strategies, given today’s low yields in those areas.
While the funds’ yields may seem attractive in isolation, it is important to remember that these yields do not include the potential incremental return from capital appreciation or income growth from the underlying markets, or the potential for active manager alpha from tactical asset allocation or security selection within the underlying PIMCO funds. Taking all of these factors – including the related investment risks – into account, we believe the All Asset and All Authority strategies are well positioned.
Q: What is the rationale for the upcoming change to the primary benchmark for the PIMCO All Asset All Authority Fund?
Cavalieri: On 13 September 2019, PIMCO filed a prospectus update for the PIMCO All Asset All Authority Fund indicating that the fund’s primary benchmark will change from the S&P 500 to the Bloomberg Barclays U.S. TIPS Index, effective 1 October 2019.
There is no change to the fund’s secondary benchmark, Consumer Price Index (CPI) + 6.5%, and there are no changes to the primary or secondary benchmarks for the PIMCO All Asset Fund, which remain the Bloomberg Barclays U.S. TIPS 1-10 Year Index and CPI+5%, respectively.
Why did we make this change for All Asset All Authority? In short, the goals are to improve clarity for shareholders regarding the nature of the fund’s investment strategy and to provide a more relevant point of comparison for returns.
Recall that the All Asset strategies are designed to seek maximum long-term real returns while diversifying investors away from mainstream U.S. equities. To that end, All Asset All Authority has historically had a low average U.S. equity beta (0.34) and net negative average exposure to U.S. equities (-11.6% of net assets) as of 30 June 2019, since inception. So while the S&P 500 is often used as a primary benchmark for asset allocation funds – which typically have equity-centric approaches – its use in the context of the highly diversifying All Asset All Authority strategy seemed less appropriate.
By contrast, U.S. Treasury Inflation-Protected Securities (TIPS) share an explicit real return orientation with the fund, and we believe the TIPS index better aligns with the fund’s return and risk attributes (e.g., higher correlation and beta, and lower tracking error), as shown in Figure 3.
In addition, changing All Asset All Authority’s primary benchmark to the Bloomberg Barclays U.S. TIPS Index creates better alignment with the All Asset Fund, which similarly uses a U.S. TIPS index as its primary benchmark.
Importantly, nothing else is changing with respect to All Asset All Authority Fund. The investment process and team remain the same, as does the fund’s secondary benchmark of CPI+6.5%, which we believe investors look to as an indication of the fund’s long-term real return aspiration.
We believe investors in All Asset All Authority (and its sister fund, All Asset) appreciate that these strategies emphasize diversifying and inflation-sensitive “Third Pillar” markets (including real assets, emerging markets, and high yield bonds) as their allocation home base, not mainstream U.S. stocks. As such, our hope is that moving from the S&P 500 to the U.S. TIPS index as All Asset All Authority’s primary benchmark will reinforce the diversifying and real return nature of the strategy, and as a result provide a more relevant point of comparison for past and future returns.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:
- How the All Asset strategies have performed during inflation surprises and potential benefits of these strategies for defined contribution plans (August 2019).
- A look at some often overlooked potential benefits of the All Asset strategies and insight into Research Affiliates’ approach to trading (July 2019)
- What an embrace of Modern Monetary Theory could mean for inflation and how PIMCO uses machine learning applications (June 2019)
- The role of machine learning in quantitative investment models and factors driving current risk tolerance within the All Asset strategies (May 2019)
- Differences between the All Asset and All Authority strategies, and their underlying allocation infrastructure (April 2019)
- Assessing investment risk in terms of the likelihood of meeting long-term wealth accumulation goals (March 2019)
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.