Arnott on All Asset

Arnott on All Asset November 2015

Rob Arnott, head of Research Affiliates, shares his firm’s market insights and allocation strategies for PIMCO All Asset funds.

Q: The Third Pillar has now lagged classic 60/40 investing for three years. I understand the benefits of contrarian investing and diversification, but when will AAF resume its winning ways, which we haven’t seen since 2012? How long is it reasonable to wait until this cycle turns?

Arnott: We’re in one of the few segments of the global macroeconomy in which customers hate a bargain:

Half off?
Get me outta here!

New, improved story and a 50% markup?
Wow, I want to invest more in time for the next 50%!

It’s human nature.

Three years ago, I was telling investors that nothing is a bargain, that U.S. stocks and bonds are expensive and most Third Pillar markets are fully priced, that our real-return targets were a stretch goal, and that we were patiently waiting for Third Pillar assets to be priced at a discount. Ironically, we saw a ton of inflows when we were conveying this cautionary message. We even predicted that when conventional wisdom feared deflation more than inflation, the Third Pillar would become cheap. That time is now.

Since 2012, mainstream U.S. stocks have risen another 50%. (New, improved story! Buy more before it’s too late!) International stocks have fared okay, but they’ve not been impressive. Bonds have moved sideways at best. The Third Pillar has trudged through a grinding three-year bear market; only REITs have fared even marginally well. Almost no one wants to rebalance into, let alone ramp up exposure to, anything that’s caused them pain. The nature of a bear market is to inflict pain and reprice markets to provide superior future returns. Now, with the Third Pillar cheap enough to provide a large advantage over 60/40, it’s no surprise that we’re seeing outflows. It happened—big time—to Jeremy Grantham in 1998–2000, and put Julian Robertson out to pasture. Of course, they turned out to be early, but right. “Early” feels like “wrong” until the turn.

A contrarian investor relishes bargains. But even so, it’s painful to pull the trigger on additional purchases of whatever has hurt most. I’m the same contrarian who earned much of my reputation by being cautious too early in 1998–99, but getting it right in 2000–02, for lagging 60/40 in 2006–07, and finally being rewarded for my patience in 2008–09. Clients may wish to sell three years into a Third Pillar bear market. I won’t. I’m comfortable with gradually ramping up our aggressiveness, now that some of these markets have become quite cheap. We saw a similar divergence between 60/40 and the Third Pillar in 1995–99, lasting even a bit longer than the current cycle. I’ve seen the play before, but I don’t know when the next act starts.

Q: The All Asset strategies are typically categorized as Global Tactical Asset Allocation (GTAA) funds. Given your asset allocation process is informed by long-term asset class expectations, what are your thoughts on the tactical nature of the All Asset strategies?

Arnott: The word “tactical” often conjures the notion of short-term market timing. We don’t believe market timing is a sustainable or repeatable approach for delivering meaningful long-term return. In our view, tactical asset allocation requires discipline to pursue return opportunities, which tend to be in markets that are out of favor, unloved and attractively priced.

The All Asset strategies embed a disciplined contra-trading mechanism, which responds to market movements and systematically varies our prospective risk levels to reflect the best long-term risk-to-reward opportunities across a global set of liquid asset classes. To achieve our real-return goals, we reduce risk and accept lower returns when prices are dear, so that bear markets won’t inflict too much pain. And we stand ready to meaningfully re-risk at far more attractive levels.

Said another way, we help investors pursue their long-term return and risk goals by taking risk when it is likely to be rewarded, and shifting to a more conservative posture when risk premiums are skinny. This approach has served us well over the last 12 years. Following the bear markets of 2000–2002 when risky assets were cheap, our strategies adopted a return-seeking stance, but not until October 2002. This risk-on stance was well-rewarded. In the late stages of the 2002–07 bull market, our strategies shifted into a more conservative posture—too early, of course! It made sense given historically high equity valuations, frothiness in real estate markets and tight credit spreads. Although we were early, trimming risk was a prudent move that buffered losses during the global financial crisis.

By late 2008, we were adding back risk assets that were looking cheap. Our allocation to commodities, EM equities, EM bonds and credit rose by 15% from October 1, 2008, to January 31, 2009. And from June 2011 to November 2011, as the market sold off in the midst of the eurozone debt crisis and fears of slower U.S. economic growth, our allocation to risk-on assets1 rose by over 20%. These tactical shifts were uncomfortable, moving us into markets that others shunned, but by materially moving the risk dial, we enjoyed two of the best calendar years we’ve ever had—2009 and 2012.

In recent years, extracting the benefit from diversification and rebalancing has been challenging, reflected by the median cross-correlation of major asset classes.2 Figure 1 shows that from 2002 to 2007, cross-correlation of asset classes averaged 31%, but during the 2008–2009 financial crisis, cross-correlation soared to 69%. In the post-crisis period, correlation levels have stayed high, averaging 56%, almost twice the pre-crisis level.

Figure 1: Cross-Asset Correlation (Median Trailing 12-Month) August 2002–September 2015

Cross-Asset CorrelationCross-Asset Correlation

All charts as of 30 September 2015.
Source: Bloomberg, Research Affiliates.

The benefits of contra-trading are reaped only when sufficient return dispersion across asset classes exists. Despite the recent lack of dispersion across asset classes, our approach continues to drive allocation shifts toward asset classes with the highest prospective returns and away from those priced to deliver low prospective returns. Thus, over the past year, we have continued to rotate away from mainstream equities and bonds and into high-yielding Third Pillar assets.

Even within the Third Pillar, contra-trading is in full play: we hold little in low-yielding TIPS, REITs and commodities, which are not priced to deliver much more than 60/40, and hold more in EM equities and bonds and some areas of credit, which have the highest expected returns across the global opportunity set. Our strategies emphasize assets with valuations that position us for good long-term future real rates of return. The spring is coiled tightly, and the snap-back, when it arrives, is likely to be impressive. Value investing and contrarian investing have been painful since 2013. I can’t wait for the turn!

Q: If inflation risks are seemingly contained today, is inflation protection even relevant? What is your outlook on near-term and longer-term inflation?

Arnott: We’re not terribly worried about near-term inflation, but the time to put inflation protection in place is when it’s cheap. That happens when investors are more afraid of deflation than inflation. When investors aren’t afraid of inflation, and inflation hedges are cheap, Third Pillar diversification is needed most urgently. With central bankers determined to create some inflation, there’s little risk of sustained deflation and certainly a risk that inflation might get out of hand. Will central bankers have the spine to inflict economic pain to rein in the first whiffs of above-target inflation?

The All Asset strategies complement your existing allocations to mainstream stocks and bonds, which will fare badly if inflation expectations rise, given current low yields. In our opinion, these strategies currently offer an opportunity to hedge against renewed inflation, earning more than twice the yield of mainstream stocks or bonds. After a 3-year bear market in Third Pillar assets and a 6½-year bull market in 60/40, we believe there is a high probability of meaningful outperformance in any market condition other than a continuing erosion of inflation expectations.

Our longer-term view of inflation has tail risk to the upside. After six years of policy distortion, the Fed decided in September to keep short-term interest rates at zero. Multiple years of loose Fed policy has encouraged yield-seeking speculation and misallocation of financial resources, creating a breeding ground for bubbles and crashes. Is it too late in the current economic expansion for the Fed to unwind the policies that led to current stretched valuations? Quite possibly, yes.

Diversification is most needed when it is least wanted. Diversification, paired with a willingness to buy what others fear, has been distinctly unhelpful over the past three years. Together, however, they have historically been a winning combination for generations of patient investors.

1 These asset classes are represented by emerging market equities, international equities, U.S. large equities, commodities, REITs, credit, EM local and non-local bonds, global bonds and inflation-linked bonds.
2 We examined the median trailing 12-month cross-asset correlations of the returns across the following major asset classes: S&P 500, Barclays U.S. Treasuries, Barclays U.S. High Yield, Bloomberg Commodity, MSCI Emerging Markets, JPM GBI-EM, and Barclays U.S. TIPS. The Pre-Crisis time period is defined as the trailing 12-month period ending August 2002 to September 2008, and the Post-Crisis time period is defined as the trailing 12-month period from October 31, 2009, onwards.
3 Our long-term capital market forecasts across a variety of asset classes can be found on our Asset Allocation site:
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

View Profile

Latest Insights


Related Funds


Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information is contained in each fund's prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative, by visiting or by calling 888.87.PIMCO. Please read them carefully before you invest or send money.

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

A word about risk: PIMCO All Asset and All Asset All Authority funds invest 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 is 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. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Commodities contain heightened risk, including market, political, regulatory, and natural conditions, and may not be suitable for all investors. 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. 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 funds will generally be higher than the cost of investing in funds that invest directly in individual stocks and bonds. The fund is non-diversified, which means that it may invest its assets in a smaller number of issuers than a diversified fund. In managing the strategy’s investments in fixed income instruments, PIMCO utilizes an absolute return approach; the absolute return approach does not apply to the equity index replication component of the strategy. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies.

Barclays Long-Term Treasury consists of U.S. Treasury issues with maturities of 10 or more years. Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Barclays Global Aggregate (USD-Hedged) Index provides a broad-based measure of the global investment grade fixed income markets. The Barclays U.S. Corporate High-Yield Index covers the USD denominated, non-investment grade, fixed-rate, taxable corporate bond market. Barclays U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. The National Association of Real Estate Investment Trusts (NAREIT) Equity Index is an unmanaged market value-weighted index of tax qualified REITs listed on the New York Stock Exchange, American Stock Exchange and the NASDAQ National Market System, including dividends. The Dow Jones UBS Commodity Total Return Index is an unmanaged index composed of futures contracts on 20 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. JPMorgan Emerging Local Markets Index Plus (Hedged) tracks total returns for local currency-denominated money market instruments in 24 emerging market countries with at least U.S. $10 billion of external trade. JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged) is a comprehensive global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations and, unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk–adjusted to a benchmark index; the excess return relative to the benchmark is alpha. Beta is a measure of price sensitivity to market movements. Market beta is 1.

This material contains the current opinions of the manager, and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world. © 2015 PIMCO