Q: What are your long-term return expectations of the All Asset strategies relative to a mainstream 60/40 portfolio?
Rob Arnott: Unlike many classic Global Tactical Asset Allocation managers who anchor on the conventional 60/40 (60% stocks/ 40% bonds),1 we diversify away from the mainstream to provide the potential for real returns at times when conventional asset classes can’t deliver them. Diversifying Third Pillar strategies, such as the All Asset funds, have performed better than 60/40 over long periods of time, albeit with sometimes daunting shortfalls when inflation expectations are falling fast, as they have over the last two years.
Since inception, the All Asset funds have beat 60/40 until recently, as we approached the late stages of a 60/40 bull market and entered a Third Pillar bear market. My expectations for the All Asset suite have improved over the last two years – my confidence in achieving our real return targets is now greater – as my expectations for 60/40 have eroded further.
Third Pillar strategies are particularly powerful when these asset classes are cheap relative to 60/40, as they are now, when inflation expectations are low, as they are now, and when 60/40 valuations are stretched, as they are now. Not surprisingly, investors want diversification least when they need it most; that is, in a very mature bull market when 60/40 is expensive, and after a Third Pillar bear market when some of these assets are cheap.
The key contributors to our long-term return expectations are income (yield) and growth in income. Sure, changing valuations play a part, but they should not play a major role in setting our long-term expectations. Over the 10 years ended March 31, 2015, the 60/40 portfolio delivered a real (i.e., net of inflation) return of 5.4%. If stock and bond valuation levels had not risen, the 60/40’s real return would have been 2.9%; that means that, over the past decade, 2.5% of the per annum return for a 60/40 portfolio came from rising P/Es and falling yields.2 We can’t rely on this marvelous valuation tailwind to continue. Very few cases exist when markets have soared on a sustained basis from today’s P/E and dividend yield levels.
Over the same 10-year period, Third Pillar assets3 generated a return of 6.2% above inflation, but after stripping away the portion of return associated with changing valuation levels, the net real return was actually a tad higher at 6.3%! Valuation changes were a considerable boon to mainstream assets, but not to Third Pillar assets, which actually got cheaper! Based on yield and growth alone, two of the most dominant and predictable contributors to long-term returns, the Third Pillar outperformed the mainstream portfolio by 3.4% annually over the past decade.
While past is not prologue, we expect a long-horizon Third Pillar-centric strategy to outperform mainstream assets, given their higher yield and higher prospective income growth. The yield premium of the Third Pillar, relative to 60/40, is reasonably correlated with future five-year return differentials (65%) and even more strongly correlated with future 10-year return differentials (80%). When the Third Pillar boasts a meaningfully higher yield than 60/40, it tends to more substantively outperform in subsequent years, as was the case in August 1998. When the Third Pillar exhibits a thinner yield premium, as it did in January 2007, its forward-looking excess return, while still positive, is smaller.
Today, U.S. equities and bonds offer a meager 2% yield for a 60/40 strategy. Most Third Pillar assets (with the exception of long Treasury Inflation-Protected Securities) have much better yields, ranging from: 2.5% in emerging market (EM) equities; 4% in REITs; 5.9% for high yield; and 6.6% in EM bonds. On average, the Third Pillar generates a yield of 3.9%, nearly twice that of 60/40. With mainstream assets at lofty valuation levels and Third Pillar assets at bargain prices, the added prospect of eventual mean reversion in valuations fuels the potential outperformance of Third Pillar investments.
Our simple analysis of this current premium implies a forward excess return of about 6% over the next five years relative to 60/40. That’s not the forward return, that’s the excess over 60/40! We view this as a reasonable baseline assumption for our strategies, not even counting the additional potential return from managing the asset mix and adding alpha.
Will mainstream 60/40 continue to outperform our holdings? It’s entirely possible near term, especially with central bank interventions, but this should pass, perhaps soon. With inflation expectations rising from their lows in January, a reversal in U.S. Fed profligacy, and supportive central bank policies in the rest of the developed and EM economies, Third Pillar outperformance seems overdue.
Q: Would you describe your process for determining overall asset allocation? In particular, what are the All Asset strategies’ sources of excess return?
Chris Brightman: The All Asset funds are designed to improve long-term real returns, to diversify an investor’s exposure away from mainstream markets and to seek assets positively correlated with inflation. The funds’ investment process employs our central investment belief that the largest and most persistent active investment opportunity is long-horizon mean reversion.4 Profiting from mean reversion requires the discomfort of contrarian positioning. To ensure that we make these uncomfortable moves, we use a systematic model-based investment process. We seek higher returns when asset class valuations are fundamentally attractive – at the times when they are feared and shunned – and shift away from popular asset classes when they are overvalued. This contrarian process is the culmination of Rob’s 30 years of managing tactical asset allocation strategies.
Our investment process is guided by a few important questions: What are the fundamentally attractive assets to own over the long term? When should we trade over the intermediate term? What insights are not captured by our models?
We seek asset classes with the potential for higher yield, stronger growth or both. Our model uses a building block approach, which informs long-term buy-and-hold asset class forecasts by summing the following: current yield plus real growth rate in income plus likely changes in valuation levels. Our forecasts do not rely on aggressive valuation reversion assumptions; we assume it takes a full 20 years for current multiples to revert to a fair level. We explain our methodology for forecasting asset class returns and display the model output on our website.5
As funds of PIMCO mutual funds, the All Asset suite combines the independent views of Research Affiliates and PIMCO. We forecast each PIMCO fund’s potential excess return over its benchmark – the estimated PIMCO alpha. Funds with an attractive record of outperformance tend to have better return forecasts and higher allocations.
After forming our asset class forecasts and PIMCO alpha estimates, we assess when to trade. Our tactical process is not about short-term market timing, but rather about rotating across a spectrum of global asset classes to select attractive entry and exit points. We consider the stage of the business cycle in deciding when to trade in or out of asset classes as valuations deviate from their long-term averages.
Finally, senior investment professionals at Research Affiliates and PIMCO collaborate monthly to review the funds’ allocation strategy and to analyze any untapped opportunities, which may not yet be priced into markets. These discussions can result in subjective adjustments (for example, overweighting funds that invested in non-agency mortgage-backed securities, following the global financial crisis) and research into improving our models (the systematic inclusion of the impact of changing demography on future returns is one such example).
Two sources of demonstrated investment expertise
PIMCO All Asset is supported by the global resources of two industry-leading firms that work together closely to pursue the funds’ objectives.
Research Affiliates’ Tactical Allocation
- Expertise in model-driven, asset allocation investment strategies
- 50 investment professionals (portfolio managers, researchers, support)
- Founded in 2002
Pimco's Active Fund Management
- Leader in active investment management across asset classes
- 400 portfolio managers and analysts
- Founded in 1971
Our alpha sources, the key contributors to the All Asset strategies’ long-term real return potential, include:
- Continual contrarian rebalancing across a vast span of markets. This process is key to harvesting incremental return over the long run. Our contrarian style and resultant allocations can often feel uncomfortable, particularly in the short term when momentum carries markets beyond fair value, but history has shown that 1) value matters and 2) a disciplined contra-trading approach rewards.
- Accessing alpha potential from PIMCO’s active management. With over 350 portfolio managers and analysts, PIMCO has a wide breadth of research and a long track record, as seen in Figure 1, which inspires our confidence in their ability to produce excess returns over the long term.
- Allocating to a range of funds6 that uniquely blends smart beta-based structural excess returns and PIMCO bond-based alpha. These strategies are based on the Research Affiliates Equity™ (RAE™) Fundamental strategy, which 1) severs the link between price and portfolio weights, 2) systematically rebalances to an index based on measures of fundamental business scale, and 3) incorporates forward-looking insights and efficient implementation of active bets – all within the construct of seeking low trading costs, large capacity and broad economic representation. The RAE Fundamental PLUS strategies combine the return of the asset class and the return of the absolute return bond alpha strategy to provide strong excess return potential over their benchmarks. As a result, the All Asset model has produced large allocations to this range of funds with roughly 37% in All Asset and 46% in All Asset All Authority, currently.
If this material is used after 30 June 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 PIMCO.com/investments or by calling 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.
1 60% S&P 500/ 40% Barclays US Aggregate indexes. “The Danger of Debalancing” highlights the well-meaning but unintentional diversification consequences of relying on popular global tactical allocation funds. http://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/358_The_Danger_In_Debalancing.aspx
2For more details, please see the Editor’s Corner “Sustainable Spending in a Lower-Return World” in the September/October 2004 issue of the Financial Analysts Journal.
3The Third Pillar is an equal-weighted passive basket of classic and stealth inflation hedges, including: long U.S. Treasury Inflation- Protected Securities (TIPS), Barclays U.S. Treasury Inflation Notes 10+ Year Index, real estate investment trusts (REITs), Dow Jones US Select REIT Index Total Return; emerging market (EM) equities, MSCI Emerging Markets Index; EM bonds, JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged); and commodities, Dow Jones UBS Commodity Total Return Index. In this exercise, we exclude commodities because of the unavailability of yield data. The Third Pillar is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product.
4 Please see “Our Investment Beliefs” for more details. http://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/316_Our_Investment_Beliefs.aspx
6 The funds are: PIMCO RAE Fundamental PLUS, PIMCO RAE Fundamental Advantage PLUS, PIMCO RAE Low Volatility PLUS, PIMCO RAE Worldwide Fundamental Advantage PLUS, and PIMCO RAE Worldwide Long/Short PLUS.