Arnott on All Asset

Arnott on All Asset - January 2015

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

You often refer to “anchoring” as a key problem in investing. Can you describe what you mean by anchoring, particularly as it relates to the All Asset funds?

Rob Arnott: Investors wonder how we can be flat-to-down in a bull market - again. They’re anchoring on mainstream stocks. Mainstream stocks are in a bull market; it’s easy to forget, in the 24-hour news cycle, that many markets are not in a bull market. Many are, in fact, approaching 2009 lows.

Investors in commodity funds do not ask why their fund is down, when stocks are up. The commodity fund is not a stock fund. By the same token, the All Asset and All Asset All Authority funds are typically an investor’s diversification away from classic mainstream stocks and bonds. Yes, we can use mainstream stocks; they are part of our toolkit. But we use them only when they are cheap. Are they cheap? No, and they have not been cheap since the aftermath of the minicrash in 2011. Yes, we can use mainstream bonds. But we use them only when they are cheap, or when we want a reserve of “dry powder,” to take advantage of other markets, as and when they become cheap. Are mainstream bonds cheap? No, but we can and do value a reserve of “dry powder,” because most markets – including some of our core inflation fighters – are not yet cheap.

What’s the role of the All Asset funds? Diversification away from mainstream, specifically to provide the potential for real returns when mainstream stocks and bonds are not able to do so. When do mainstream stocks and bonds fail in this role? When inflation expectations are rising. Here’s where the “anchoring” problem is most self-evident. Inflation expectations are in a powerful bear market; 10-year inflation expectations (the breakeven inflation rate for 10-year Treasury Inflation- Protected Securities (TIPS) versus Treasuries) fell from 2.48% to 2.16% in 2013 and to 1.70% in 2014.* That’s a 33% decline in inflation expectations.

Commodities are 20 months into a severe bear market. Emerging market (EM) bonds are in a bear market. EM stocks are in a bear market and in the fourth year of a sputtering sideways-to-down market. We’ve ramped up exposure to each of these as they’ve fallen. What’s in a bull market is – most particularly – U.S. stocks and bonds, two asset classes that we emphatically do not anchor on. Viewed from the perspective of mainstream stocks and bonds, any diversification will look disappointing this far into a bull market. Viewed from the perspective of some of our diversifying inflation-hedging markets, current prices look – especially on a relative basis – very cheap.

Diversification is always painful in a bull market – the longer the bull market, the more the pain. All Asset Fund has managed to achieve modest gains despite this horrific headwind in tumbling inflation expectations; All Asset All Authority has delivered slender losses. Against U.S. stocks, this looks awful. But, that’s anchoring against an irrelevant guide that dominates the news cycle. Against the world of inflation hedges and diversifications away from mainstream stocks and bonds, these results are unsurprising.

A conventional response to this environment is, “Get me outta my inflation hedges!” A contrarian response is, “What a wonderful time to be ramping up my inflation hedges, when most investors seem to think that money printing has no consequences and deflation is a greater long-term risk than inflation!”

Q: What will it take for these diversifications away from the mainstream to bear fruit?

Arnott: The answer is fourfold. First, this diversification is potentially great over a market cycle, in sideways and turbulent markets, brilliant in bear markets, and relentlessly painful in bull markets. Diversification always, always, always tests our patience during extended bull markets in our core investments (U.S. stocks and bonds in current circumstances). Diversification is for defense, a mainstay for when an investor’s mainstream investments are struggling. The proof is in the pudding: As shown in Figure 1, on a 1-year rolling basis since their inceptions through December 31, 2014, All Asset and All Asset All Authority have always outperformed traditional 60/40 (60% stocks/ 40% bonds) portfolios when the latter delivered negative returns. On average, the excess one-year returns during these 60/40 down markets were 6% for All Asset and 12% for All Asset All Authority.

Arnott on All Asset January 2015 charts

If this material is used after 31 March 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. The All Asset/All Authority Funds maximum offering prices (MOP) returns take into account the 3.75%/5.50%, respectively, maximum initial sales charge. The All Asset/All Asset All Authority class A gross/net expense ratios are 1.495%/1.365% – 2.40%/1.68%, respectively. The All Asset/All Asset All Authority institutional gross/net expense ratios are 0.995%/ 0.865% – 1.95%/1.23%, respectively. For performance current to the most recent month-end, visit or call 888.87.PIMCO. The net expense ratio reflects a contractual expense reduction agreement through 31 July 2015 and the accounting treatment of certain investments (e.g., reverse repurchase agreements) but do not reflect actual expenses paid to PIMCO.

Second, the yield spread (or, more accurately, the carry spread) is huge. This means that we are being paid to diversify. Our current yield is lofty, which helps to mitigate downside risk. Our debt coverage ratios are solid.

Third, we are positively correlated to inflation expectations. Of course, with inflation expectations in free fall, our core assets are in a bear market. That’s actually a wonderful thing. People can ramp-up their inflation hedges on the cheap. And, because we came into these markets with a very defensive posture, because even the inflation hedges were fully priced two years ago, we’ve only been lightly clipped by this bear market. (If you recall, we predicted that inflation hedges would be available on the cheap, at some point when investors were more worried about deflation than inflation. That time is now.)

Fourth, markets mean-revert. What’s expensive eventually falters; what’s cheap eventually rebounds. Contra-trading against these markets will pay off for the patient investor. A comparison between U.S. and EM stocks – using the enhanced versions of Research Affiliates Fundamental Indexes (RAFI®) – provides a neat example. The Enhanced RAFI Emerging Markets Index had a dividend yield of approximately 3.5% as of December 31, 2014. Add in 2% for projected real growth in EM and 2% for inflation, and we’d be looking at a long-term expected return of roughly 8%, right there. For the U.S., the same arithmetic gives us only a 5% starting return: We begin with a dividend yield of 2% for Enhanced RAFI U.S. Large Index for the same period, plus 1% for real growth and 2% for inflation. Suppose the Enhanced RAFI U.S. and EM indexes, which are priced at Shiller P/E ratios of 26x and 11x, respectively, as of December 31, 2014, were to meet in the middle at 18.5x in 10 years. For the Enhanced RAFI EM Index this rise from its current 11x would mean 5% a year from rising valuation levels, which would take the return to 13% a year, or 11% in real (minus 2% inflation) terms. For the Enhanced RAFI U.S Index, the fall from 26x to 18.5x would mean a 3% per year headwind from lower valuation levels, which would take the return to 2% a year, or zero in real – after inflation – terms. If Enhanced RAFI has any structural alpha, as we believe it has, then both figures – for the U.S. and EM – would be higher. But an 11% gap in annual returns between the two is a perfectly plausible outcome. This is the kind of mean reversion that may occur after the extravagant market distortions introduced by our central bankers in recent years.

How soon will this happen? I prefer not to play that guessing game, while waiting for the payoff that comes from, in my view, a near-certain mean reversion in the years ahead.

Q: Why not hold some U.S. stocks until the Fed starts to tighten, or some other catalyst for a market top exists? In particular, why not lift the short position in All Asset All Authority until there’s evidence that the bull market is well and truly over?

Arnott: To buy U.S. stocks, one must believe that they are priced to offer better returns than are available in other markets, or that we have a sell discipline, a special knowledge of when the merry-goround will stop, etc. We don’t believe the former. As for the latter, we don’t believe we have that special knowledge or skill to divine a market top ahead of the pack particularly in the short-term.

As with most investors, my one-year outlook is pretty useless: It's not my forte. Although I harbor the illusion that I might be right 52% of the time, this is not meaningful enough to get ahead of the pack as a market timer. I have realized that in my 30 years of investing, I’m considerably better as a long-term value investor. I’d much rather choose to stay away and invest in markets that are more attractively-priced. In the long run, markets are driven by value, and our goal is to add value over the long fiduciary horizon.

I’ve said before that our short position in All Asset All Authority is not a direct expression of a bearish view of U.S. equities. Instead, shorting provides us with the ability to leverage our exposure to third pillar inflation hedges with no more risk than the All Asset strategy. We do this very deliberately. The result is a more differentiated, more independent and more diversifying exposure to the market for inflation hedges, as evidenced by the excess returns in 60/40 down markets as discussed in the previous question.

For those who “anchor” on 60/40, the All Asset Fund will be – by far – the more comfortable of the two strategies. It’s long-only and unleveraged. For those who truly want a differentiated, diversifying inflation hedge that will be very lightly correlated with their mainstream holdings – and who do not mind the maverick risk that this implies – All Asset All Authority is by far the more diversifying strategy.

* Source: FRED (Federal Reserve Bank of St. Louis)

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Robert Arnott

Founder and Chairman, Research Affiliates

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