Arnott on All Asset

Arnott on All Asset July 2015

Rob Arnott, head of Research Affiliates, and Jason Hsu, Research Affiliates’ co-founder and vice chairman, share their firm’s market insights and allocation strategies for PIMCO All Asset funds.

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:

  1. We are outright bearish.
  2. We want to reduce the volatility and equity beta of our levered positioning.
  3. 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,”

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.

The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Jason Hsu

Co-Founder, Research Affiliates

Related Funds


Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative or by visiting Please read them carefully before you invest or send money.

A word about risk:The PIMCO All Asset and All Asset All Authority Funds invest in other PIMCO funds, and performance is subject to underlying investment weightings, which will vary. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations and economic and political risks, which may be enhanced in emerging markets. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Commodities contain heightened risk, including market, political, regulatory, and natural conditions, and may not be suitable for all investors. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Derivatives and commodity-linked derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks, such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs, and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. The cost of investing in the funds will generally be higher than the cost of investing in funds that invest directly in individual stocks and bonds. The fund is non-diversified, which means that it may invest its assets in a smaller number of issuers than a diversified fund. In managing the strategy’s investments in Fixed Income Instruments, PIMCO utilizes an absolute return approach; the absolute return approach does not apply to the equity index replicating component of the strategy. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies.

Barclays Long-Term Treasury consists of U.S. Treasury issues with maturities of 10 or more years. Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Barclays Global Aggregate (USD Hedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The Barclays U.S. Corporate High-Yield Index the covers the USDdenominated, non-investment grade, fixed-rate, taxable corporate bond market. Barclays U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. The National Association of Real Estate Investment Trusts (NAREIT) Equity Index is an unmanaged market weighted index of tax qualified REITs listed on the New York Stock Exchange, American Stock Exchange and the NASDAQ National Market System, including dividends. The Dow Jones UBS Commodity Total Return Index is an unmanaged index composed of futures contracts on 20 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. JPMorgan Emerging Local Markets Index Plus (Hedged) tracks total returns for local currency-denominated money market instruments in 24 emerging markets countries with at least U.S. $10 billion of external trade. JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged) is a comprehensive global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations and, unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Beta is a measure of price sensitivity to market movements. Market beta is 1.

This material contains the current opinions of the manager, and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world. © 2015 PIMCO

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY 10019, is a company of PIMCO.