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:
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
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.