Q: You say that the All Asset suite is intended to be a real return solution for investors. What metrics are useful in gauging the efficacy of the All Asset suite for real spending return?
Arnott: From the beginning, the All Asset strategies have consistently had a real return orientation, specifically intended to help investors diversify their existing holdings in mainstream stocks and bonds. A conventional balanced portfolio is massively “short” inflation. Consider that the 9% return earned in a classic 60/40 portfolio over the last 30 years would have been impossible if bond and stock yields had not tumbled. What permitted bond yields to fall from double digits to a very low single-digit, or stock yields to fall from 5% to less than 2%? A collapse in inflation expectations—along with other factors, such as demography—caused investors to demand an ever-lower yield to protect against a vanishing risk of inflation.
By seeking asset classes positively correlated with inflation, we aim to be a real return solution for our investors. Said another way, we strive to improve our clients’ long-term sustainable real spending income. What do we mean by this, and why does it matter? Most people measure wealth in terms of the dollar value of a portfolio. We believe a far better gauge of a portfolio’s true value is the real sustainable income stream, or the sustainable spending power, it is likely to deliver. In 2004, in a Financial Analysts Journal “Editor’s Corner,” I coined the expression “sustainable spending”1 to describe this idea—a concept that is as relevant now as it was then.2
An interesting nuance that can be gleaned from our study of sustainablespending is that bear markets have a limited impact on a portfolio’s spending power. For example, let’s consider the single worst bear market in U.S. capital markets history—the Great Depression. From September 1929 to June 1932, the average equity investor’s portfolio fell by 83%.3 Even in the face of deflation, the real versus nominal loss was 79%! As Ben Graham frequently pointed out, there is a grave difference between a temporary loss of value (a drop in price) and a permanent loss of capital (from bankruptcy or default). For investors who sold after the stock market crash of 1929, theirs was a disastrous and permanent loss.
For the balanced 60/40 investor, especially one who was disciplined about rebalancing, the damage from the 1929 crash would have been shockingly mild, most particularly from the perspective of sustainable income. Even though stocks were down 79% in real inflation-adjusted terms, 10-year government bonds were up 17% in real terms. If 60% of the portfolio lost 79% in the crash and 40% of the portfolio gained 17%, the portfolio’s net loss was “only” 41%. Had an investor been foolish enough to rebalance into the crashing stock market, the real loss would have escalated to 51%. Rob Arnott, head of Research Affiliates, and Chris Brightman, Research Affiliates' chief investment officer, share their firm’s market insights and allocation strategies for PIMCO All Asset funds.
But there was good news in the midst of this very serious market debacle. As a result of the crash, stock market yields rose from 3.1% to 13.1%, while 10-year bond yields finished more or less unchanged at 3.7%. The starting 60/40 portfolio sported a yield of 3.35%. (It’s hard to imagine today that people thought this yield was shockingly low!) With no rebalancing, the 60/40 portfolio would have morphed into a bond-centric 21/79 mix, with a yield of 5.34%. Although portfolio value was down by 41% in real terms, its yield was up by over 60%. The market crash low of $59, which yielded 5.34%, delivered a sustainable income that was a scant 4% lower than the starting $100, which yielded 3.35%—sustainable income was essentially unchanged!
For investors with the courage to rebalance into a crashing market, the portfolio value would have dropped by 52%, but the yield would have risen to 9.34%. Sustainable income would be up by 33%. Keep in mind that rebalancing during a trending market feels very painful. But through the lens of sustainable spending—measured in real income distributions—the loss disappears. Although the market downturn during the Great Depression was devastating, the cost of living also fell, and portfolio income rose, so that the patient balanced investor’s lifestyle actually improved. Even the loss of capital was temporary: the recovery was immense as the portfolio’s value, and real spending power, achieved new highs.4
To shift our focus from the dollar value of our portfolio to its real sustainable spending power can be difficult, even uncomfortable. Such a shift requires discipline and courage to temper our inherent human instinct to sell what has been disappointing and chase the investments that have treated us best. The All Asset strategies are designed to systematically and steadily rebalance out of our best-loved (and expensive) investments and into investments at their most frightening, so that they are priced with good risk premiums in mind.
Once we resolve to shift our attention to sustainable spending, metrics can help gauge the efficacy of real spending returns. As my 1929 stock market crash example showed, dividend yields(and real yields on bonds) are a simple measure of sustainable real spending because dividends generally rise with inflation. Another approach is even simpler: we can measure the value of our portfolio against the changing cost of a 20-year inflation-indexed annuity.5
Figure 1: Standardized performance
Total annual operating expenses for the All Asset All Authority Fund are 2.320% and 1.870% for A shares and institutional shares, respectively. Net annual operating expenses are 2.23% AND 1.78%. Total annual operating expenses for the All Asset Fund are 1.525% and 1.025% for A shares and institutional shares, respectively. Net annual operating expenses are 1.375% and 0.875%.
If this material is used after 30 September 2015, it must be accompanied by the most recent Performance Supplement. Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Investment return and the principal value of an investment will fluctuate. Shares may be worth more or less than original cost when redeemed. Current performance may be lower or higher than performance shown. For performance current to the most recent month-end, visit pimco.com or by calling 888.87.PIMCO.
* The inception date is for the oldest class of shares (the Inst. share class). The inception date for all share classes of the All Asset Fund is 31 July 2002. The inception date for the institutional shares of All Asset All Authority Fund is 31 October 2003. A shares were not offered for All Asset All Authority Fund until July 2005. Returns prior to that date apply the institutional share class returns with the charges and expenses of class A shares. Performance reflects changes in share price, reinvestment of dividends and capital gains distributions. All periods longer than one year are annualized.
When measured in terms of dollar value, the All Asset Fund (AAF) has delivered a since-inception return and risk in line with that of a balanced 60/40 U.S. core asset portfolio. But through the lens of real sustainable spending, the picture looks quite different. When we reframe the fund’s risk by measuring the volatility of a real income annuity that can be purchased with the assets of AAF, risk (or volatility) falls from 9.3% to 7.7%, a natural result of its real return orientation. Because a traditional 60/40 portfolio is “short” inflation (i.e., it will respond well to a world of falling inflation expectations), its real income stream has an annual volatility of 11.0%.
As shown in Figure 1, only a handful of asset classes have performed better than AAF since inception and they have all had greater volatility in real annuitized income. A few asset classes have given investors less volatility in real annuitized sustainable spending, but no asset class offered more return with less real annuitized risk.
Figure 2: Return and Standard Deviation of Annuitized Income, August 2002–June 2015
Importantly, the journey for AAF over the past 10 years has been far steadier with much less volatility, as measured in terms of real sustainable spending, than the path of a 60/40 portfolio. In fact, the real spending power for an investment in T-bills is almost exactly as volatile as the real spending power of an AAF investment. During the 2007–09 global financial crisis, a 60/40 portfolio suffered a 33% decline from peak to trough in sustainable spending, whereas the sustainable spending of AAF dropped “only” 21% over the same period. Even TIPS would have been hit with a 7% drop in sustainable real spending, peak to trough, during this savage bear market. Since early 2009, a 60/40 mix has enjoyed a near-linear bull market. The mix’s real annuity has soared over the last three years as TIPS’ yields rose and the cost of the real annuity fell, as many real return assets experienced a bear market.
During a bear market in real return assets, it’s natural and instinctive to abandon real return–oriented strategies, especially when the mainstream—a conventional 60/40 asset mix—has been so very rewarding. Staying the course with out-of-favor markets in a protracted momentum-fueled investing environment can be viscerally unnerving. But growth-dominated momentum markets do not last forever, nor does the illusion that inflation is gone for good. So, for those who focus on real spending levels, market downturns—in these self-same inflation-sensitive markets—can potentially turn out to be terrific opportunities to rebalance into high-yielding assets, offering the opportunity to ratchet sustainable spending even higher. Soon enough, markets remember that valuation is like gravity, overwhelming in its force no matter the power of temporary winds.
Q: What is your outlook for emerging market currencies, and how has it affected your current allocation in the funds?
Brightman: Let’s start with our central investment philosophy: long-horizon mean reversion is the largest and most persistent active investment opportunity.6 Past is not prologue; winners of the past rarely persist (though they can persist beyond the patience threshold of many investors). How do we translate this belief into investment strategy? Contrary to human nature, we buy what is cheap and feared, and sell what is dear and beloved. This resolve, to buy assets whose prices have plummeted, and which investors now fear, is deeply uncomfortable. This discomfort is fundamentally linked to the excess returns earned by the successful contrarian.
The All Asset strategies are designed to systematically embed this high-conviction contrarian behavior in a strategy that complements an investor’s holdings of mainstream stocks and bonds. Because our focus is protecting against inflation, a non-U.S. dollar bias is entirely normal. Pairing our inflation focus with the recent surge in the U.S. dollar, up 20% since last summer, our preference for non-U.S.–denominated assets gradually increases. Many EM currencies, including the Brazilian real, Malaysian ringgit, and Indonesian rupiah, have fallen to historic lows against the U.S. dollar. So too have developed economy currencies, such as the euro and the yen, but these developed economies also have anemic bond yields, unlikely to attract investment capital to their currencies. It’s no surprise, then, that some of the largest allocations in the All Asset suite are to funds with high emerging markets (EM) currency exposure, which in aggregate represent approximately one-third of total assets.
In past Insights, we have discussed the favorable long-term outlook for EM asset classes broadly. Higher yields, secular improvement in credit quality, constructive demographic trends, stronger prospective growth, and attractive Shiller price-toearnings multiples buttress our view. Strong fundamentals and reasonable pricing make EM local bonds and unhedged equities compelling opportunities. Cheap currencies make these offerings all the more interesting.
We view EM currencies as being among the most attractive sources of return available to investors today for the following reasons:
- First, EM currencies generally offer a high real cash yield
particularly when compared to other market opportunities — an advantage we believe is likely to persist. Historically, on average, EM currencies offer a 2.5% real yield gain, relative to major developed currencies, whose real yields mostly reside in negative territory.
- Second, we believe EM currencies offer the potential for significant exchange rate appreciation. This is due in part to higher economic and productivity growth rates in EM economies compared to developed economies. The EM currencies are also cheap. As of June 30, 2015, the spot real exchange rate of a basket of EM currencies7 versus the U.S. dollar was discounted 18% against the previous 10-year average and fell within the cheapest decile since November 1994. Although value can take time to pay off, history shows that the greater the exchange rate discount, the larger the subsequent appreciation of the spot rate return.8
- Finally, EM currencies are a core position—whenever they are cheap—because they offer positive correlations to U.S. inflation. As Rob discussed in the last question, the All Asset suite of strategies is designed to be a real return solution. The EM currency exposure is a stealth inflation fighter. Since 1997, the JPM ELMI+ TR Index has exhibited a positive 20% quarterly correlation to year-over-year changes in realized and expected inflation, comparable to U.S. TIPS, even though U.S. TIPS are contractually linked to U.S. inflation and EM debt is not. As, and when, developed-market countries turn to financial repression to inflate away the real value of unsustainable debt levels, we expect the currencies of developed countries to depreciate against EM currencies.
Are we concerned about the impact of the potential increase in U.S. interest rates on our positioning in EM currencies? Not at all. Negative real rates are called “financial repression” for a reason—they are a stealth wealth tax that leads to malinvestment and slow economic growth. Higher interest rates and stronger GDP growth in the United States are typically associated with faster global growth and increasing risk appetites, both of which could bode well for EM asset class returns. Rising rates also usually go hand-in-hand with rising inflation expectations. With the sole exception of the 2013 Taper Tantrum, EM currencies delivered positive returns in all periods since 1994 when the 10-year yield rose by 75 bps or more.
This Q&A is taken from a recent discussion between Rob Arnott, portfolio manager and head of Research Affiliates, Chris Brightman, chief investment officer of Research Affiliates, and PIMCO product manager John Cavalieri about PIMCO’s All Asset suite and how the funds are being positioned in the current environment.
1Please see “Sustainable Spending in a Lower-Return World,” the “Editor’s Corner” in the September/October 2004 issue of the Financial Analysts Journal. http://www.cfapubs.org/doi/abs/10.2469/faj.v60.n5.2645
2“Align the Design: Considering and Evaluating Target Date Glide Paths” by Stacy Schaus and Ying Gao (May 2015) http://www.pimco.com/EN/Insights/Pages/Align-the-Design-Considering-and-Evaluating-Target-Date-Glide-Paths.aspx
3Many reports on the Great Depression leave out the dividends on stocks and bonds. They matter.
4All of these figures are pre-tax. The real devastation inflicted on investment capital during the Great Depression was neither from the plunge in real portfolio values, which was daunting, nor from a plunge in sustainable spending from these portfolios, which was nonexistent for any investor who was unleveraged, well-diversified, and did not panic. The real devastation was from taxes. In 1932, in response to a plunge in tax revenues, Congress and the Hoover Administration agreed to boost taxes to 56% at the $100,000 income level and 63% at the $1 million income level. From 1925 to 1931, the top Federal tax bracket was 25%, which kicked in at an income of $100,000; adjusted for inflation, that’s equivalent to an income of $1.5 million. The top 1% of society barely made it into the 10% tax bracket, a rate that doesn’t even exist today!
5Good historical data on the cost of an inflation-indexed annuity do not exist, but we can determine the cost from the TIPS yield curve by calculating how much it would cost to buy a TIPS portfolio that would pay, for example, $100 a month, indexed to inflation, for the next 20 years.
6Please see “Our Investment Beliefs” (October 2014) by Chris Brightman, Jonathan Treussard, and Jim Masturzo. https://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/316_ Our_Investment_Beliefs.aspx
7The basket consists of the following EM countries and weights: Russia (21%), Brazil (15%), South Korea (14%), India (13%), Mexico (12%), Poland (12%), Indonesia (8%), and South Africa (5%).
8From November 1994 to June 2015, the correlation between the EM exchange rate valuation and the subsequent five-year return of the EM spot rate has been−0.5.