Arnott on All Asset December 2015

Q: What are the parallels between today’s market environment and the late 1990s? What do these observations suggest about the current prospects of Third Pillar-based strategies?

Robert Arnott: First, most of you chose these strategies as a complement to your existing investments in mainstream stocks and bonds, as a way to protect against market environments (notably rising inflation expectations) that are devastating to these mainstream holdings, and as a way to invest where relative valuation is attractive. We are grateful, and we understand the performance fatigue that value and Third Pillar investors are suffering these days. We have seen this before.

Current investment conditions bear resemblance – albeit with less valuation extremes – to those of the late 1990s, and have been a tremendous headwind to Third Pillar-centric diversifiers and strategies. It’s common to overlook the fact that it is precisely these market conditions have historically set the stage for extended periods of strong returns. The worst-ever span for Third Pillar1 investors ran from 1995–1998, with huge shortfalls relative to mainstream 60/40 investors in three of the four years. Over a year before the tech bubble came to a close, the Third Pillar began to recover, beating 60/40 in a bull market year. From 1999–2003, when U.S. equities still had one last bull market year before its collapse, the Third Pillar rose by 37% cumulatively, translating into an astounding 61% outperformance of the S&P 500! For nine consecutive years, the Third Pillar beat 60/40, from 1999 through 2007.2 Past is never prologue. But if history is any guide, comparable starting conditions have led to large and prolonged outperformance in diversifying asset classes.

So, how similar are current conditions, compared with the conditions that presaged this best-ever span for Third Pillar investing? We observe four major similarities between the late 1990s and today, as seen in Figure 1. Here, we are comparing with yearend 1998, rather than end-1999, because Third Pillar assets began outpacing mainstream 60/40 investors in 1999, over a year before the tech bubble burst.

Comparisons of Broader Market Conditions, 2015 vs. 1998

Both then and now, we endured a severe “bear market” in inflation expectations. When inflation expectations hit a basement low of 0.9% in December 1998, it jumped to 2.0% within 6 months. More recently, over the past three years, 10-year inflation expectations3 plummeted by 45%; from April 1997 to December 1998, the decline was a little larger. In both cases, inflation expectations ranked in the bottom decile of historical inflation expectations. As the impact of the crash in oil prices begins to fade from headline inflation in the coming months, a reversion towards the much-higher core CPI seems nearly inevitable and deflation fears are likely to dissipate.

The only other time emerging market currencies were this cheap was in 1998, when emerging markets fell out of favor, hit by the Asian currency crisis and the Russian default. What a remarkable opportunity today! Cheap EM currencies translate into an improvement in export competitiveness, which in turn, leads to the possibility of positive earnings shocks in EM. These earnings surprises – still ignored by the punditry – would be very supportive of local emerging stock and bond market returns and reward us as we hold meaningful allocations in EM equities and local EM debt.

There are other similarities. EM currencies and markets were savaged by the Asian currency crisis, relative to a soaring U.S. dollar and stock market; by August 1998, the Shiller P/E ratio for EM stocks reached an all-time low of 8.5x.4 More recently, EM currency rates tumbled from a 20% premium four years ago to a 25% discount in September 2015. A basket of EM currencies is trading at bargain-basement levels that are deep into the cheapest quintile, when compared with the last 20 years. By 1998, emerging market stocks were trading at a 70% discount to the S&P 500, when measured by the Shiller P/E ratio; today, the discount is 60%. What did this translate to? In 1998, for the U.S., the subsequent 10-year nominal returns was essentially zero (and, of course, negative in real returns). For EM markets, it was 10% per annum.5 Where are we now? A seven-year U.S. bull market rally has pushed U.S. valuations to the top 10% of the historical record, while EM valuations have tanked to the bottom 4% from a quarter-century history. Today, EM markets are trading at a Shiller P/E that has historically presaged double-digit real returns over the subsequent decade.6

And, both in 1998 and today, global value stocks were savaged relative to soaring growth stocks. The nearly 8% to 9% underperformance of value vs. growth stocks in the MSCI World Index in the trailing 12 months ended September 30 ranks in the worst decile of relative performance for value vs. growth since 1976. The beauty of the All Asset Fund, and the beauty of fundamental indexation-based strategies within the All Asset funds, is that these strategies have a ratchet-like effect of moving to a more aggressive value posture whenever value goes out of favor. That way, when the snapback comes, we wind up recovering considerably more, relative to the shorter-term loss experienced during the time when value was out of favor. An interest rate hike or a correction in mainstream stocks and bonds could easily trigger that rebound in value.

As was the case more than 15 years ago, the current environment will pass, and perhaps soon. Today’s conditions are dominated by broadly held, consensus-driven expectations that deflation is a bigger concern than inflation, the dollar will continue to soar, and the U.S. equity bull market will persist. Today’s environment, as it was in the late 1990s, resembles a strongly coiled spring in that the opportunity for an impressive snapback is increasingly likely. Even a very small shift in these views would likely benefit the Third Pillar handily.

During trying times, it’s easy to forget why anyone ever made the decision to invest in real return-oriented, diversifying strategies. Like us, you likely did so because you wanted assets that can help diversify risk, defy mainstream asset class vulnerability to inflation, and at prices that can offer substantial forward-looking long-term returns, at a time when mainstream stocks and bonds may not. The basis for your original decision is – if anything – more relevant now than ever.

Q: Investors are increasingly adopting alternatives and other out-of-mainstream asset class strategies in their portfolios, is All Asset a reasonable solution to meet the same objectives?

Jason Hsu: Compared to more than a decade ago when the All Asset strategies were launched, investors are allocating more to alternatives and other Third Pillar asset classes. Many are in search of higher returns to meet long-term portfolio needs or desire to achieve reduced volatility and correlation to the equity market. But by and large, the additions to these unconventional assets, such as real estate, commodities, high yield securities and emerging market stocks and bonds, have been modest. Based on a survey of 116 public plans as of June 2015, the average allocation to mainstream asset classes was still nearly 70%.7 So despite moderate forays into alternative markets in recent years, the bulk of investors’ exposure resides in conventional asset classes.

This equity-centric home bias characterizes one of the persistent challenges that investors face: the lack of true diversification given far too much concentration in equity risk. Coupled with low future returns in mainstream equities and their vulnerability to inflation, these issues today were – somewhat ironically – at the core of our motivation to launch the All Asset funds back in 2002 and 2003.

We seek to achieve our objectives by rotating across a whole spectrum of global inflation-fighting asset classes that provide better risk-adjusted return potential than an equity-centric policy mix. Our strategies are designed to complement investors’ mainstream investments by seeking diversifying assets that exhibit higher yields, faster growth, or both, along with a positive correlation with inflation – any whiff of which tends to hurt mainstream asset classes. Third Pillar asset classes offer us a measure of protection against inflation while improving our likely returns relative to the classic 60/40 balanced portfolio.

Couldn’t we achieve a similar outcome if investing in a sampling of passive Third Pillar indexes? Unlikely, for a few reasons. First, the All Asset strategies offer a lower equity beta and stronger protection in down equity markets, as reflected by a down market capture of 28% versus 46%8 for the Third Pillar. The All Asset strategies are simply a better diversifier. Second, we shift the portfolio along the risk continuum as conditions dictate, rotating into the asset classes yielding the most attractive prospective returns. Our portfolio volatility is far from static. Furthermore, the All Asset strategies have access to two additional sources of excess returns: PIMCO fund alpha and the incremental return from continual contrarian rebalancing across a span of markets. Finally, practicing disciplined contrarian rebalancing is hard to do; buying what’s out of favor goes against human nature.

1 The Third Pillar index is an equally weighted index primarily consisting of the following asset classes: U.S. high yield, long U.S. TIPS, EM local bonds, EM equities, REITs and diversified commodities. From 2003 to the present, these asset classes are represented by the following indexes: BofA ML US HY BB-B Rated Constrained, Barclays US TIPS 10+ Year, JPM GBI-EM Global Diversified, MSCI Emerging Markets Index Gross, Dow Jones U.S. Select REIT Total Return and the Dow Jones-UBS Commodity Index Total Return. As we go back in time, we replace the constituent index using a similar proxy with a longer history: these indexes include the IA Barclays US HY Corporate Bonds TR, S&P GSCI TR, FTSE REIT All REITs TR, JPM ELMI and Barclays TIPS.
2 It bears mention that the Third Pillar was clobbered – even harder than 60/40 – in 2008. The reason that All Asset and (especially) All Authority beat 60/40 by such a wide margin was our tactical decision to be hyper-defensive in the months leading up to the 2008/09 market crash.
3 The source of the U.S. 10-year break-even inflation is FRED. Prior to 1 January 2003, the 10-year US break-even inflation is calculated as 10-Yr U.S. Treasury minus average of JPM 1-10 Year TIPS Index and JPM 10+Year TIPS Index (where available). The JPM 10+ Year TIPS Index begins in May 1998.
4 The U.S. CAPE ratio is provided by Robert Shiller. The emerging market CAPE ratio is based on the MSCI EM Index (prices and earnings in U.S. dollars), which provides earnings data starting in 1995. Prior to 1995, the MSCI Index data were augmented by data from Global Financial Data (GFD), which reports both total return and price index data for emerging markets. Using this data, it is possible to infer the dividend yield for each period that is used, along with the average payout ratio, from the current MSCI data to calculate the earnings per share and the CAPE prior to 2005. Details on creating a historical emerging markets index can be found in the Credit Suisse Global Investment Returns Yearbook, 2014.
5 Please see our October 2015 Fundamentals, “Investing versus Flipping.”
6 Our own forecast is for a more modest 8% real return. Our methodology and assumptions are explained on our asset allocation website:
7 Please see our October 2015 Fundamentals, “Investing versus Flipping.”
8 Down market capture is a measure of a fund’s performance relative to the index’s return during down markets (i.e., when the S&P 500’s return was negative). The data source is Bloomberg.


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