Q: The All Asset funds have a low allocation to long-only U.S. equity strategies, and All Asset All Authority has a meaningful allocation to the short equity strategy. What is your rationale for avoiding, or shorting, the U.S. equity market?
Rob Arnott: Let’s start by recognizing that from the rear-view mirror, avoiding – and especially shorting – soaring U.S. stocks has been very painful. But from the context of our strategies’ objectives, is this alarming? Forgive me if my answer is alarming, but I would say “absolutely not.” Most balanced strategies and conventional global tactical asset allocation managers anchored on a balanced 60/40 portfolio (comprised of 60% stocks and 40% bonds) offer their clients essentially no diversification. None. They merely mirror what their clients already own. For strategies, such as the All Asset (AA) suite, that are intended to be investors’ diversification away from conventional assets, we increase our clients’ exposure to mainstream stocks only when mainstream stocks are cheap; our clients already have the equity exposure they want when stocks are sensibly priced or expensive, and we do them no service at all by mirroring that exposure.
Unfortunately, diversification is least wanted and most painful when it’s most needed – in a mature bull market. When traditional core holdings (First and Second Pillar assets) are in a mature late-stage bull market, and diversifying investments (Third Pillar assets) are suffering through a bear market (i.e., are getting cheaper), it’s a wonderful opportunity to rebalance away from winning holdings and into diversifying asset classes, on the cheap. Very few investors think this way, so the many investors who are trend chasing are taking the other side of our trades, and
ultimately funding the long-term success of contrarian strategies like ours.
We consciously and deliberately aim to be a very differentiating Third Pillar investment, a profoundly diversifying portfolio. Hence, a low mainstream equity beta in the AA funds or our use of the short strategy in our All Authority strategy are wholly consistent with our core objectives. Over the past decade, the average beta to the S&P 500 has been 0.45 times for All Asset and 0.35 times for All Authority. For all funds in the Morningstar Tactical Allocation and World Allocation categories with at least a 10-year track record ending December 2014, the median beta is 0.68– that’s more equity-heavy than even a 60/40 balanced portfolio! – and the median correlation with the S&P 500 is 0.92 – near-perfect correlation with stocks!
As Figure 1 shows, these supposedly diversifying strategies have an average correlation of 0.88 with their clients’ 60/40 allocations. Of these 221 funds, over the last decade only two had a lower correlation relative to a 60/40 portfolio than the All Authority fund, and neither had a higher return. Even more interesting, among these tactical and world allocation strategies no linkage exists between correlation and 10-year return. Bolder, morediversifying strategies, such as ours, did not perform worse than timid 60/40-tracking strategies, even in a 10-year span in which stocks generally fared well, beating bonds and cash by 3.0% and 5.7%, respectively.
Generally, we short the U.S. equity market for one or more of three reasons:
- We are outright bearish.
- We want to reduce the volatility and equity beta of our levered positioning.
- We see relative-value opportunities and additional sources of alpha that are worth harvesting.
In today’s environment, the fund’s short position combines all three of these, with a primary emphasis on the third. Let me explain.
In terms of bearishness, the valuation arguments are familiar territory, but have little impact on near-term performance. Such arguments are further supported by the end of quantitative easing (QE) – partly offset by continued QE in Europe and Japan – and the surge in the dollar, which puts pressure on U.S. earnings. None of this, however, is enough for us to take a fiercely bearish position.
Most investors aren’t accustomed to the notion of a GTAA manager that – under normal circumstances – can or should lightly trim equity beta to create a more-differentiated, morediversifying portfolio for the end client. But this is the norm for the All Authority fund, and one of the main reasons the average net allocation to U.S. equities is -8.0%. In a market like the one we experienced in 2004, we did buy U.S. equities to a maximum net exposure of over 50% – but only because U.S. stocks were cheap. Our current short position allows us to leverage our Third Pillar holdings that have high multi-year expected returns, while keeping portfolio risk low, and even more importantly, our contribution to our clients’ aggregate portfolio risk even lower.
Our short positioning allows us to capture relative-value opportunities and sources of return potential across and within asset classes. Our current above-average short position to U.S. equities is broadly a function of trading away increasingly lower yield and growth, and substituting them with 1) asset classes offering increasingly higher yields, higher growth, or both, and 2) funds that uniquely blend smart beta–based structural excess returns and PIMCO bond–based alpha. The result is a moredifferentiated, more-independent, and more-diversifying exposure to inflation hedges.
In a bear market, the short position adds value, so I do not need to address that scenario. But if the “Yellen put” prevails, and no bear market materializes, with the 40% in leverage we are
permitted to use (up to 1.5 times invested capital), our 15% short position allows us to buy 25% more in Third Pillar asset classes.
So, how does our short S&P 500 exposure work for us? It enables us to pursue a higher expected return while limiting our total volatility and enhancing our diversification potential. We expect Third Pillar asset classes to earn a blended real return of 4%+, and potentially higher when considering the excess return potential from PIMCO active management and our RAE™ approach in equities. By contrast, we believe that U.S. equities will have an annual real return of <1%, both in the short term (12 months) and the long term (10 years). By using our leverage to simultaneously amplify our Third Pillar holdings and shorting U.S. equities, we exploit that relative return opportunity in a largely volatility-neutral manner. Of course that combined position is expected to also lower our correlation to U.S. equities. We think that threesome – higher expected return, similar volatility and greater diversification benefits – is a win for our investors as it is realized over the market cycle.
Q: Have the funds always been Third Pillar strategies, or has your investment style changed? Why has the allocation to the Third Pillar in All Asset All Authority risen in recent years?
Jason Hsu: Rob coined the phrase “Third Pillar” five years ago in 2010,1 a year when All Asset posted strong returns. Most investors limit their portfolios to two pillars: 1) mainstream equities, which provide participation in economic growth, and 2) mainstream bonds, which offer steady income while reducing volatility. But in a high-inflation environment both disappoint. Adding a third pillar – asset classes that are positively correlated with inflation and/or offer higher yields and faster growth – to most investors’ portfolios can provide meaningful improvement in real return and in diversification away from conventional asset classes. The suite’s since-inception average allocation to the Third Pillar has been 77% in All Asset and 86% in All Authority. Our core objectives and our investment style are no different today than they were over a decade ago.
The use of Third Pillar assets in the AA funds has risen in the last few years for several reasons. First, PIMCO’s Third Pillar toolkit has gained breadth. One new tool in the toolkit is alternative, or absolute return, strategies. These alpha-focused funds, which do not have a beta benchmark, have allowed us to lower portfolio risk without sacrificing expected positive return. No
such alternative funds existed before 2008. Today, we have eight alternative strategy funds, which constitute nearly one-fifth of the portfolio’s overall allocation. We anticipate that allocations
to the Third Pillar will rise as new compelling diversification strategies are added to our opportunity set.
Second, over the past few years, many Third Pillar asset classes have become increasingly attractive relative to mainstream stocks and bonds, and a number of diversifying inflation hedges have
been offered at a discount. Since January 2013, the yield advantage of an equal-weighted Third Pillar composite2 relative to the mainstream 60/40 portfolio has risen from 57% to over 90%, as Figure 2 illustrates. Our value-oriented, contra-trading strategies emphasize these asset classes, bargains that we believe offer premium yields and the highest prospective returns.
Lastly, our average allocation to the Third Pillar in the All Authority fund is higher than in its early days because leverage is currently very inexpensive. Higher amounts of leverage have allowed us to capture more relative-value opportunities across the most attractive Third Pillar asset classes. We consider these alternative strategies to be where we store our “dry powder.”
1 Rob’s first published use of the term “Third Pillar” was in the September 2010 white paper “Fighting Yesterday’s War,” researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/F_2010_Sept_401k_fighting_yesterdays_war.aspx
2The Third Pillar composite is an equal-weighted passive basket of classic and stealth inflation hedges, including long TIPS, REITs, EM equities, EM bonds, and commodities. In this exercise, we exclude commodities because of the unavailability of yield data.