All Asset All Access, November 2019
- Research Affiliates has formalized partnerships with key academic thought leaders, including Campbell Harvey and Juhani Linnainmaa, to conduct research and thought leadership with our team, with the aim of informing and improving the methodology and positioning of our strategies.
- Recent coauthored journal papers span areas of factor investing and applications of quantitative methods, while current research projects include examining the costs to trade various factors, determinants of the time-varying factor performance of value, the impact of equity market cycles on factor strategies, and the decomposition of the drivers of alpha.
- We view an analysis of beta-adjusted returns (net-of-fee return per unit of U.S. equity beta) as a more relevant approach to assessing the historical performance of the All Asset strategies relative to a heterogeneous – and growing – peer universe.
- All Asset Fund and All Asset All Authority Fund both exhibit structurally lower equity beta than their peers, which is consistent with their design as portfolio diversifiers.
In this issue, Chris Brightman, chief investment officer of Research Affiliates, discusses how its research partnerships with key academic advisors are critical to informing its methodology and positioning. Brandon Kunz, partner and multi-asset strategist at Research Affiliates, examines the All Asset strategies’ beta-adjusted performance versus peers. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: What role do Research Affiliates’ academic advisors, including Cam Harvey and Juhani Linnainmaa, serve in your research efforts? What are some highlights of their research?
Brightman: True to the name of our firm, Research Affiliates has made research the foundation of our investment process and approach. We seek to understand how markets function and how investors behave. We study existing theory and practice, but also challenge conventional wisdom. Our research tests our investment beliefs and informs how we design, implement, and manage strategies. Through our research efforts, we remain committed to our mission: to provide insights and products to the global investment community for the benefit of investors.
Before turning to members of our academic advisory panel, let’s begin with the research and investment team at Research Affiliates. As of 30 September 2019, our research and investment management team includes 41 professionals, over 80% of whom hold a Ph.D., master’s degree, Certified Financial Analyst (CFA) or Financial Risk Manager (FRM) designation. Our researchers make up nearly half of our total staff and have on average 13 years of investment experience. To be sure, we are a research-intensive firm.
Since the founding of our firm 17 years ago, we have also continually forged connections with and leveraged knowledge from the academic community. Today we have formalized our engagement with key academic thought leaders who are well-regarded in their fields of research, such as Campbell Harvey, professor of finance at the Fuqua School of Business at Duke University, and Juhani Linnainmaa, professor of finance at Tuck School of Business at Dartmouth College. Both are partners and advisors of Research Affiliates.
Our advisors conduct research and thought leadership with our team. Of note, Cam also works with me to direct and coordinate firmwide research initiatives. We’re delighted to have someone of Cam’s background and experience in this role, as he is one of the most distinguished academics and awarded researchers in the fields of finance and economics. Prior to joining the firm in 2017, he published more than 125 scholarly articles on topics spanning investment finance, emerging markets, corporate finance, behavioral finance, financial econometrics, and computer science and received eight Graham and Dodd Awards/Scrolls for excellence in financial writing from the CFA Institute.
Recent journal papers we coauthored with our advisors span areas of factor investing and applications of quantitative methods.1 Current research projects include an examination into the costs to trade various factors, determinants of the time-varying factor performance of value, the impact of equity market cycles on factor strategies, and the decomposition of the drivers of alpha, among others.
Our partnership with academic advisors is intended to benefit our research efforts and ultimately our clients. We seek to adhere to high research standards, carefully avoid overfitting (i.e., creating statistical models with too many parameters relative to the data set), and ensure that our studies are robust, and we welcome peer review. As always, critical research observations and findings continue to inform and improve the methodology and positioning of our strategies, including the All Asset strategies.
Q: Given the diverse mix of portfolio styles that characterizes the universe of global tactical asset allocation (GTAA) funds, how might one create something closer to an apples-to-apples assessment of the All Asset strategies’ returns relative to peers?
Kunz: It is true that funds within the asset allocation categories encompass a diverse mix of allocation approaches and “home base” allocations. That can make peer group comparisons challenging. Specifically, do observed differences in returns reflect a different structural “home base,” or do they reflect the skill of the manager given a particular “home base”?
In our view, the key element that defines the heterogeneity among the All Asset strategies’ peers within Morningstar’s Tactical Allocation2 category, as well as the strategies in the World Allocation3 category, is the amount of average equity beta (see Figure 1).
Perhaps not surprisingly, the average fund in Morningstar’s Tactical Allocation and World Allocation categories has exhibited an average U.S. equity beta of 0.57 and 0.58, respectively, which is very close to the 0.60 beta of a traditional U.S. 60% stock/40% bond mix.4 Of course, there are plenty of category peers who fall into higher-beta and lower-beta cohorts.
All Asset Fund and All Asset All Authority Fund both exhibit structurally lower equity beta than their peers, which is consistent with their design as portfolio diversifiers. In fact, they represent two of only three funds with an average U.S. equity beta below 0.40 over the past decade (with All Asset coming in at 0.37 and All Asset All Authority at 0.28).
This historical result is intentional. We at Research Affiliates manage the All Asset funds to seek maximum real return potential while maintaining a structural emphasis away from mainstream equity risk and into diversifying and inflation-sensitive markets, all while targeting levels of volatility similar to conventional-portfolio averages. Adhering to this process has helped the All Asset funds provide diversifying returns relative to traditional portfolios and has led to historical strong performance during equity bear markets, high-volatility regimes, and reflationary environments.5
So, if the Morningstar asset allocation categories have a heterogeneous mix of funds with respect to average equity beta, and the All Asset strategies exhibit intentionally lower equity beta than both conventional and higher-beta peers, how might one consider a performance comparison that normalizes for these different “home base” portfolio styles? Simply comparing historical absolute returns, in our view, does not normalize for these differences. For example, after a decade-long U.S. equity bull market, a portfolio with structurally higher equity beta may look “superior” to a low-beta peer – but what if that high-beta fund has underperformed relative to its “home base” style (e.g., relative to its own benchmark)?
Comparing risk-adjusted returns offers an improvement, in our view, but that approach only normalizes for the level of total risk, not the compositional type of risk.
Instead, we believe that a comparison of beta-adjusted returns (i.e., net-of-fee return per unit of U.S. equity beta) is a more relevant approach because it measures the return efficiency of funds regardless of their “home base” portfolio style. Said differently, it helps normalize return comparisons across funds regardless of where the funds exist on the diversification spectrum.
In Figure 2, we show the percentile rank of All Asset Fund’s beta-adjusted returns versus Morningstar peers since inception and over the past 10, five, three, and one years.
In segmenting the category peers by the level of average equity beta, we are cognizant that tactical management of funds’ equity beta around their average levels also takes place. In the All Asset funds, we have utilized tactical flexibility to increase or reduce portfolio-level equity beta around their low average levels when we deem appropriate. For example, when we observe attractive valuations for procyclical assets, positive short-term price momentum, or falling probabilities of economic slowdown, we have tended to increase the All Asset funds’ portfolio-level equity beta to be more return-seeking.
On the other hand, when we observe stretched valuations, negative price momentum, or rising probabilities of economic slowdown, we have tended to reduce the All Asset strategies’ portfolio-level equity beta in favor of countercyclical assets and other dry-powder strategies. This dynamic allocation process has led to rolling U.S. equity betas that intentionally diverge over tactical horizons from the since-inception averages of 0.39 for All Asset and 0.35 for All Authority. Specifically, over rolling three-year periods, All Asset Fund’s U.S. equity beta has been as high as 0.56 and as low as −0.06 (with highs and lows of 0.56 and −0.05 for All Authority). [Note that even our highest rolling equity betas are lower than the average equity betas of allocation category peers!]
The benefit of tactically managing the All Asset strategies’ equity beta (and total portfolio risk) is that it creates the potential for favorably asymmetrical upside and downside participation. In contrast, a fund with a perfectly static beta would be expected to move up and down with equity markets in equal proportions. Interestingly, this can actually be value-detracting if market volatility is symmetrical, since (for example) a 10% market decline followed by a 10% market rebound would result in a net loss. However, the All Asset funds have exhibited more upside participation and less downside participation, which has contributed to each fund’s historical returns (see Figure 3).
Since its inception on 31 July 2002, All Asset Fund has delivered the highest returns per unit of U.S. equity beta versus the institutional share classes of all 18 other surviving peers in Morningstar’s Tactical Allocation and World Allocation categories. Furthermore, and despite the peer universe across both categories having grown to 149 surviving funds with at least a three-year track record, All Asset Fund has delivered top-decile results over the last three and 10 years in the combined peer universe (see Figure 2) and results well within the top third of all peers over the last five years.
Applying this analysis to All Asset All Authority Fund provides similar results. Since its inception on 31 October 2003, All Authority Fund has also delivered the highest beta-adjusted returns versus all 20 surviving peers in Morningstar’s Tactical Allocation and World Allocation categories. Over a 10-year period, its rank is just outside the top quartile, and while its five-year result is within the bottom quartile, All Authority’s beta-adjusted returns have been in the top decile for the past three years.
Bottom line, we view an analysis of beta-adjusted returns as a more relevant approach to assessing the historical performance of the All Asset strategies relative to a heterogeneous – and growing – peer universe. Such an analysis not only creates what we view as a more relevant peer comparison, but also aids in determining whether the All Asset funds are adhering to diversification objectives that we deem similarly important to their aspirational real return objectives.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:
- Why Research Affiliates’ contrarian philosophy may add value over the long term and how the growing likelihood of a global economic slowdown is affecting positioning (October 2019)
- Asset class bubbles and “anti-bubbles,” factors driving yields, and the benchmark change for All Asset All Authority (September 2019)
- How the All Asset strategies have performed during inflation surprises and potential benefits of these strategies for defined contribution plans (August 2019)
- A look at some often overlooked potential benefits of the All Asset strategies and insight into Research Affiliates’ approach to trading (July 2019)
- What an embrace of Modern Monetary Theory could mean for inflation and how PIMCO uses machine learning applications (June 2019)
- The role of machine learning in quantitative investment models and factors driving current risk tolerance within the All Asset strategies (May 2019)
The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate, and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the sub-advisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.
1Interested readers, please see “Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing” by Cam Harvey, Rob Arnott, Vitali Kalesnik, and Juhani Linnainmaa, and “A Backtesting Protocol in the Era of Machine Learning” by Cam Harvey, Rob Arnott, and Harry Markowitz.
2Morningstar’s category definition for the Tactical Allocation category is as follows: “Tactical Allocation portfolios seek to provide capital appreciation and income by actively shifting allocations across investments. These portfolios have material shifts across equity regions, and bond sectors on a frequent basis. To qualify for the tactical allocation category, the fund must have minimum exposures of 10% in bonds and 20% in equity. Next, the fund must historically demonstrate material shifts in sector or regional allocations either through a gradual shift over three years or through a series of materials shifts on a quarterly basis. With a three-year period, typically the average quarterly changes between equity regions and bond sectors exceeds 15% or the difference between the maximum and minimum exposure to a single equity region or bond sector exceeds 50%.” Morningstar includes All Asset Fund and All Asset All Authority Fund within the Tactical Allocation category.
3 We also consider the Morningstar World Allocation category in the All Asset funds’ peer group because the All Asset strategies also invest in a broad array of the world’s asset classes and seek to add value through tactically changing their asset mix. Morningstar’s category definition for the World Allocation category is as follows: “World-allocation portfolios seek to provide both capital appreciation and income by investing in three major areas: stocks, bonds, and cash. While these portfolios do explore the whole world, most of them focus on the U.S., Canada, Japan, and the larger markets in Europe. It is rare for such portfolios to invest more than 10% of their assets in emerging markets. These portfolios typically have at least 10% of assets in bonds, less than 70% of assets in stocks, and at least 40% of assets in non-U.S. stocks or bonds.”
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 www.pimco.com. Please read them carefully before you invest or send money.
The performance figures presented reflect the total return performance for the Institutional Class shares (after fees) and reflect changes in share price and reinvestment of dividend and capital gain distributions. All periods longer than one year are annualized. The minimum initial investment for Institutional, I-2, I-3 and Administrative class shares is $1 million; however, it may be modified for certain financial intermediaries who submit trades on behalf of eligible investors.
Investments made by a Fund and the results achieved by a Fund are not expected to be the same as those made by any other PIMCO-advised Fund, including those with a similar name, investment objective or policies. A new or smaller Fund’s performance may not represent how the Fund is expected to or may perform in the long-term. New Funds have limited operating histories for investors to evaluate and new and smaller Funds may not attract sufficient assets to achieve investment and trading efficiencies. A Fund may be forced to sell a comparatively large portion of its portfolio to meet significant shareholder redemptions for cash, or hold a comparatively large portion of its portfolio in cash due to significant share purchases for cash, in each case when the Fund otherwise would not seek to do so, which may adversely affect performance.
Differences in the Fund’s performance versus the index and related attribution information with respect to particular categories of securities or individual positions may be attributable, in part, to differences in the pricing methodologies used by the Fund and the index.
There is no assurance that any fund, including any fund that has experienced high or unusual performance for one or more periods, will experience similar levels of performance in the future. High performance is defined as a significant increase in either 1) a fund’s total return in excess of that of the fund’s benchmark between reporting periods or 2) a fund’s total return in excess of the fund’s historical returns between reporting periods. Unusual performance is defined as a significant change in a fund’s performance as compared to one or more previous reporting periods.
A word about risk:
The fund invests 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 are 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. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. 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. Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged. 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 Fund will generally be higher than the cost of investing in a fund that invests directly in individual stocks and bonds. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
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. The up and down capture is a measure of how well a portfolio was able to replicate or improve on phases of positive benchmark returns, and how badly the portfolio was affected by phases of negative benchmark returns
Bloomberg 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 $500 million par amount outstanding. Bloomberg Barclays U.S. TIPS: 1-10 Year Index is an unmanaged market index comprised of U.S. Treasury Inflation-Protected Securities having a maturity of at least 1 year and less than 10 years. CPI + 500 and CPI + 650 Basis Points benchmark is created by adding 5% or 6.5% to the annual percentage change in the Consumer Price Index (CPI). These indexes reflect seasonally adjusted returns. The Consumer Price Index is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Bureau of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.
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