Founder and chairman of Research Affiliates, Rob Arnott, explains why investing in diversifying strategies appears critical today and discusses how the All Asset strategies are designed to serve as a real-return-oriented return stream for investors. Brandon Kunz, partner and multi-asset strategy lead, discusses the latest research findings applied to the investment process of the All Asset strategies and what impact they have had on the portfolios. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.

Q: Why is the rationale for investing in real-return-oriented, diversifying strategies relevant today?

Arnott: I’ve regularly said that it takes courage to rotate into diversification before it is needed or self-evident. While most investors understand that the concept of diversification is powerful, its long-term proposition has been questioned and even dismissed by some commentators in recent years. In a momentum-fueled bull market for mainstream stocks and bonds, every penny invested elsewhere inflicts an opportunity cost. It’s awfully tempting to abandon diversifying strategies when a conventional 60/40 asset mix (60% stocks and 40% bonds) has been so very rewarding. Staying the course with out-of-favor markets can be viscerally unnerving.

But, in a bear market for equities, or a protracted span of lackluster returns, we typically wish we’d committed far more of our money into diversifiers. We all know that past is not prologue, that the dot-com-fueled 1990s were followed by the lost decade of the 2000s. Will the roaring 2010s repeat in the 2020s, or will we see another reversal, as we did when the first tech bubble of 2000 burst?

Let’s not forget that the fabulous 2010s began with market valuation levels similar to – indeed cheaper by some measures than – the 1990 valuations that facilitated the spectacular run of the 1990s. And that current valuations are similar to – indeed by some measures more expensive than – the 2000 valuations that marked the end of that tech bubble and set the stage for the bleak 2000s. Accordingly, at Research Affiliates we think the 2020s will bear closer resemblance to the 2000s than to a repeat of the 2010s. Whether you agree with this view or not, the relevant question is, “Do I want to invest part of my portfolio to hedge against a repeat of the 2000s? Or do I want to stake my entire portfolio on a repeat of the 2010s?”

Based on current valuations, which in our view are high for most mainstream U.S. stocks and bonds and reasonable for most diversifying asset classes, diversification in investor portfolios may be more important now than at almost any time since the tech bubble burst in 2000. A wide dispersion in valuation levels across global markets offers an opportunity for investors who are willing to rotate away from the deceptively “safe haven” of expensively priced U.S. large cap equities and generally low yields of mainstream bonds. We believe many Third Pillar asset classes, notably emerging market (EM) equities, EM bonds, and real estate investment trusts (REITs), are priced to offer higher yields and better long-term prospective returns (we broadly define Third Pillar asset classes to include emerging markets, high yield bonds, and real return investments).

At Research Affiliates, we believe successful long-term investing requires us to embrace the truism that diversification is most valuable when it is least wanted. As reinforced by history, many of those who do so are ultimately rewarded. Imagine how well the investor who uses diversifiers, instead of more conventional allocators, will likely fare when Third Pillar markets are winning? Oh, wait, we saw that movie from 2002–2012!

Q: The All Asset strategies are designed and managed to serve as a diversifying return driver in investor portfolios. How has Research Affiliates sought to reach long-term return targets in a way that is consistent with the strategies’ objectives?

Arnott: Historically, the All Asset strategies have indeed offered diversifying returns, even in an environment that has been challenging for diversifying markets and in the face of daunting headwinds for value equity investors. Recall that we seek to provide investors with meaningful diversification away from mainstream equity risk, while delivering meaningful long-term real return potential. Since its launch on 31 July 2002 through 31 March 2021, the All Asset Fund (institutional share class) delivered a net-of-fees return of 7.16% per annum, beating the Bloomberg Barclays U.S. TIPS (1-10 Year) Index by 302 basis points, and also outpacing our long-term return objective of CPI + 5% by 7 basis points (see Figures 1 and 2 for detailed fund and benchmark performance). Importantly, over this full span, the strategy has deliberately maintained a modest exposure to mainstream equities, as reflected by an average U.S. equity beta of 0.42x.

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

Through 31 March 2021, in the 12 months since the lows of the COVID crash, and in the 145 months since the lows of the global financial crisis in February 2009, it was nearly impossible to beat the S&P 500, essentially the best-performing market in the world. But, the All Asset Fund delivered cumulative (not per annum) returns of 37.13% and 164.91%, respectively, from these market lows (institutional share class, net of fees), against cumulative returns in the benchmark Bloomberg Barclays U.S. TIPS (1–10 Year) Index of 8.12% and 54.58%, respectively.

Our mission for the All Asset strategies has always been to address three investor issues: 1) to help investors diversify away from their overwhelming reliance on equity market risk by providing a Third-Pillar-centric strategy as a one-stop-shopping source of both diversification and inflation protection, 2) to improve the long-term real return potential when mainstream stocks and bonds offer low prospective returns, and 3) to counter mainstream assets’ vulnerability to inflation by emphasizing markets that are positively correlated with inflation. This mission has not changed since we first launched the strategies nearly 19 years ago.

Q: What gives you the assurance that these strategies can reliably serve as a diversifying solution for investors?

Arnott: Let me emphasize that the All Asset strategies are focused on Third Pillar strategies. These are divergent strategies designed to have a home-base positioning centered on diversifying markets and a low mainstream equity beta. Few investors would want to have the majority of their investment portfolio in All Asset, for the same reason that they should not want to have all of their money in mainstream stocks and bonds. The latter are the first and second pillars of a successful long-term strategy, while the All Asset strategies span that third pillar. While All Asset seeks to diversify whatever risk investors have in their mainstream two-pillar holdings, our holdings in mainstream stocks and bonds tend to diversify whatever risks we hold in All Asset.

Since their launch through 31 March 2021, our strategies’ average exposure to Third Pillar markets was 76.2% for All Asset and 85.7% for All Asset All Authority. Over the same span, the All Asset strategy has maintained an equity beta to U.S. stocks of 0.42x since its inception. For the All Asset All Authority strategy, its equity beta over its lifetime has averaged 0.40x.

These equity beta levels are indeed quite different from those of a typical balanced strategy or global tactical asset allocation manager. Despite various monikers and claims, most supposedly diversifying asset allocators are primarily two-pillar strategies, spanning mainstream stocks and bonds with modest allocations to diversifying out-of-mainstream markets. When we surveyed funds in the Morningstar’s Allocation and Alternative categories three years ago, including all surviving funds with a track record as long as the All Asset strategy, the average equity beta of a fund was 0.64.^[i] That’s higher than the beta of a conventional 60/40 mix and far exceeding the All Asset strategies!

An investor who buys the typical fund in Morningstar’s Allocation and Alternative categories, expecting that these funds will provide diversification, may be surprised to learn that they’ve merely doubled-down on what they already own. If the All Asset strategy is combined with a passive 60/40 portfolio, the result could be powerful: Historically, diverting 20% of a 60/40 portfolio into the All Asset Fund would have beaten 91% of all Morningstar World Allocation, Tactical Allocation, and Alternative managers over the last five years, 96% over the last 10 years, and 87% since the launch of the fund on 31 July 2002.

Running a true diversifying strategy is far easier said than done. It’s often painful, and challenges investor patience when mainstream stocks and bonds are on a roll, and it feels no less alien when mainstream markets are floundering. We consciously aim to be a differentiating Third Pillar source of returns – a diversifying portfolio that complements investors’ portfolios in traditional markets. It’s what we do.

Q: Will you provide an update on any research insights that have made their way into the All Asset strategies’ investment process?

Kunz: In last August’s edition of All Asset All Access, Cam Harvey, a senior advisor to Research Affiliates, mentioned an ongoing research initiative to create a suite of quantitative models that attempt to identify and exploit tactical opportunities while complementing the All Asset funds’ existing tactical models. One outcome of this research initiative was the publication of a working paper entitled, “Decoding Systematic Relative Investing: A Pairs Approach”.^[ii]

This paper introduces a next-generation framework to relative value investing. Rather than adhere to a rank-based approach to overweighting assets with the most attractive signal scores (e.g., momentum, mean reversion) and underweighting assets with the lowest scores, this framework first selects the most potentially profitable pair trades that exhibit three desirable traits:

1) high own-asset signal-return predictability

2) low cross-asset signal correlation

3) low cross-asset signal-return predictability

Using this framework, we first identify what are likely to be the most profitable pair trades for a given predictive signal, and we then construct a tactical overlay representative of that signal’s suggested overweights and underweights on a monthly cadence.

Importantly, any signal linked to persistent returns can be applied to this framework, so we’ve created various tactical overlay portfolios utilizing numerous definitions of the following signals:

• Short-term momentum: Trending markets are indicative of short-term underreaction to news, time-varying risk tolerance, and compensation for crash risk when risk-appetite shifts or news surprises cause trends to change.
• Long-term reversal: Reverting markets may act as compensation for bearing uncomfortable, contrarian investment positions with the potential for prolonged underperformance until fear subsides or momentum’s overreaction to news is recognized.
• Volatility: Heightened volatility over longer time spans can be indicative of dislocations exploitable over a subsequent multi-year horizon, when volatility mean-reverts and prices resume an upward trend. Short- to medium-horizon subdued volatility can be persistent and indicative of continued upward-trending prices in the near to medium term.
• Momentum turning points: Asset returns tend to follow predictable patterns based on agreement or disagreement of both fast and slow momentum signals. This approach determines conditional expected returns following slow and fast momentum agreement (or disagreement) regimes, and selects the asset pair spreads with the highest conditional return potential in the creation of the overlay portfolio.
• Sharpe ratio: Elevated risk-adjusted returns can be indicative of continued resistance to mean reversion, and persistently subdued risk-adjusted returns can be indicative of increased potential for future outperformance.

In historical simulations, these tactical overlay portfolios have outperformed generation-one relative value approaches while exhibiting low (or negative) equity beta and being lightly correlated with one another. These benefits, coupled with their being complementary to All Asset’s existing tactical considerations and long-horizon return forecasting models, have led to their being incorporated into All Asset’s investment process over the last two quarters. While All Asset’s value-oriented, contrarian allocation process and underlying PIMCO fund alpha remain the primary drivers of its return profile, we see today’s modest weight on these next-generation overlays as having the potential to deliver annualized incremental value add of a few tens of basis points in the coming years.

Q: How have these tactical overlays affected the All Asset strategies since being incorporated into the portfolios?

Kunz: The initial performance impact of these tactical overlays has been decidedly positive for the All Asset strategies, consistent with their historical simulations. In historical simulations, an equally weighted mix of the aforementioned five signals was highly return-efficient – with a Sharpe ratio well in excess of 1.0 – and with the additional benefits of modest volatility, limited maximum drawdown, and a near-zero equity correlation. Naturally we apply substantial haircuts to these results before assessing how to scale and incorporate them into the actual All Asset portfolios.

Since their inclusion into the All Asset process in Q4 of 2020, these tactical overlay portfolios have exceeded our expectations by delivering standalone returns in the All Asset Fund (Institutional share class, net of fees) of 0.96% through 30 April 2021. Of course we recognize this is a limited out-of-sample period, but we are nonetheless pleased to see the initial results of our next-generation research insights delivering attractive incremental returns to shareholders.

For further insights, please watch this video on the All Asset strategies with Rob Arnott, founder and chairman of Research Affiliates, and Chris Brightman, chief investment officer of Research Affiliates. They discuss diversification benefits, long-term return estimates, and the outlook for the value-oriented All Asset strategies.

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.