Launched over a decade ago, well before the term “smart beta” was coined, the PIMCO Research Affiliates Equity (RAE) Fundamental equity strategies have
successfully navigated through the financial crisis and an extraordinary market environment in which growth has outperformed value for an extended period.
Recently, however, the outperformance of growth versus value has intensified, and this has challenged RAE Fundamental equity strategies. In the following
interview, Research Affiliates Chairman and smart beta investing pioneer Rob Arnott provides his perspective on recent market dynamics and why these
strategies may present unique opportunities for equity investors today.
Q: Rob, you are broadly credited with pioneering the “smart beta” movement. You are also a portfolio manager for the PIMCO RAE Fundamental equity
strategies. Remind us of the philosophy and process behind these strategies.
Rob Arnott: PIMCO RAE Fundamental is based on a simple premise: Valuation matters. At its core, as is the case with smart beta strategies
more broadly, it is a contrarian rebalancing strategy designed to outperform the market by breaking the link between price and portfolio weighting in order
to systematically take advantage of the market’s constantly changing sentiment.
RAE Fundamental, which is exclusively available through PIMCO, has continuously evolved based on our latest research findings. These equity strategies
build upon Research Affiliates’ original work on the Fundamental Index methodology by incorporating additional insights on smart beta, return premia, risk
diversification and implementation.
The PIMCO RAE Fundamental portfolios start with a fundamentals-based portfolio construction process, selecting and weighting companies by fundamental
measures of size – sales, cash flow, dividends and book value. Rebalancing to these fundamental weights helps the portfolios adhere to the “buy low, sell
high” axiom. The act of rebalancing is inherently contrarian. In effect, it requires the sale of the market’s most sought-out companies and the purchase of
out-of-favor companies. PIMCO RAE Fundamental portfolios position themselves to take advantage of mean reversion as a result.
Additionally, PIMCO RAE Fundamental equity portfolios incorporate momentum and quality screens, plus processes designed to diversify active weights. The
momentum screen seeks to protect against catching the proverbial “falling knife” while also working to avoid rebalancing aggressively out of a rapidly
appreciating position. The quality – or financial health – screen incorporates a number of measures designed to reduce or eliminate exposure to companies
that are either distressed, lacking growth prospects or applying aggressive accounting techniques. And the risk-diversification processes redistributes
active “bets” with the goal of optimizing long-term risk-adjusted returns.
Q: Performance has been challenged as of late. Why?
Arnott: When appropriately implemented, a contrarian, disciplined, fundamentally-weighted approach should add value over the long run so
long as stock prices continue to mean-revert after deviating from their intrinsic fair value – as they have throughout history. However, mean-reversion
timing is inherently difficult to predict. Trends often last longer than any reasonable valuation measure would suggest they should. The screens embedded
in the PIMCO RAE Fundamental portfolio construction process are helpful, but have not been enough to prevent a contrarian strategy with a disciplined
rebalancing approach from lagging in a market where value has underperformed growth by over 8% globally1 over the past 12 months ended September 2015.
The PIMCO RAE Fundamental strategies attempt to systematically access the value premium efficiently via rebalancing, although the degree of value exposure varies over time. The value tilt will be lower when value companies are relatively expensive, and the value tilt will be higher when value companies are
relatively cheap. This means that at the moment, the value tilt is higher than average, creating both a meaningful headwind for recent returns and fabulous
positioning going forward. History has repeatedly shown us that due to the power of mean reversion, rebalancing can work over the long run, and
conditioning a valuation-biased portfolio on other systematic exposures, namely quality and momentum, may lead to even better outcomes.
Q: On a more granular level, what exposures contributed to recent underperformance?
Arnott : The names vary by region, but the value underperformance I mentioned can be traced to a few primary drivers. Commodities-related
businesses have been punished recently, while the internet and biotech industries have seen valuations continue to rise.
Energy firms have suffered as the price of oil has fallen, and RAE rebalanced into high-quality energy firms as they fell in price only to see them become
cheaper still. Now that oil is below $50/barrel, the markets fear it will fall to $20/barrel, and fear is an inherently uncomfortable feeling. Yet,
sometimes the best investment opportunities are those that are uncomfortable. (It was not that long ago that the dominant fear was $200/barrel oil – in
2008 when oil was trading around $130). There is no question that higher oil prices are generally better for energy companies than lower oil prices. The
more relevant question for investors relates to current valuations. Is the decline and potential future decline in oil prices properly reflected in prices
today, or has the market over-extrapolated? A lot of bad news is priced into this sector in developed markets. Even more is priced into energy companies in
Biotech and select internet companies constitute the other side of this story. As these industries have continued to appreciate, relatively speaking, the
RAE process has resulted in underweights that have negatively affected performance versus cap-weighted index benchmarks. For reference, the price-to-sales
ratio for biopharma firms in the Russell 2000 was 14x at the end of August versus a sector average of 1x for the rest of the index. (I have to quote a
sales, not earnings, multiple for these firms as many of them do not even have earnings!) And within the S&P 500, the current price-to-earnings ratio
is close to 40x and 30x for the internet and catalog retail and internet software and services industries, respectively, versus 18x for the S&P 500 as
a whole as of September 30.
Q: What do you expect from the RAE Fundamental strategies going forward?
Arnott: The extraordinary divergence in growth versus value is noteworthy, and not entirely dissimilar from certain market characteristics
circa 1999, in the months leading up to the burst of the tech bubble. Interestingly enough, it was our observations in the aftermath of the tech bubble
that led to our work on the Fundamental Index methodology. We may not know exactly which stocks are overpriced and underpriced – and by how much – but we
do know that the stock market is not perfectly efficient. We have been taught this again and again.
Likewise, we do not have an opinion on the appropriate valuation levels for specific companies, but we do know that valuation matters. Mean reversion is a
powerful force, and due to the disciplined process that we follow, we believe that the PIMCO RAE Fundamental portfolios will be well-positioned when it
happens. Growth has outperformed value by about 2% 2 per year since the launch of the original RAE Fundamental strategies over a decade ago, in contrast to
the typical well-documented value return premium. Between the possibility for mean reversion and the potential for the return of the value premium, I
believe that these strategies offer a relatively unique and attractive investment opportunity today.
1 Based on the performance of MSCI All Country World Index Value (-10.79%) vs. Growth (-2.48% for 12 months ended 30 September 2015.
2Based on the performance of Russell 1000 Value (5.82%) vs. Russell 1000 Growth (7.71%) from 31 December 2014 through 30 September 2015.