Issue 30: 2015

Investment Spotlight

Exploring Timelines and Pillars

Fund managers from GMO, LLC, and PIMCO, LLC, discuss their investment strategies.

Ben Inker (left), CFA, co-head of asset allocation at GMO, LLC, a sub-advisor on certain Wells Fargo funds; Robert D. Arnott (right), Founder and chairman of Research Affiliates, portfolio manager at PIMCO.

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For this issue’s Investment Spotlight, Capital Acumen’s editors spoke with two renowned money managers about investment strategy, risk and diversification.

PART ONE: BEN INKER

Ben, please describe some of the fundamentals of your investment approach.

The goal of our benchmark-free strategy is to generate returns of inflation plus 5% over the long term. We invest in stocks, bonds and other asset classes, including some liquid alternative strategies. We look for securities that are priced to give a decent risk-reward tradeoff, and all this is done without regard for a benchmark. We usually ignore assets that are not priced to deliver a decent return for the risk we’re taking. We have few limits on the number of stocks we can hold versus bonds or cash. Even so, it’s hard to imagine our being fully invested in only one asset class. If stocks were extraordinarily attractive relative to bonds and cash, we could conceive of going as high as 85% in stocks. On the other hand, if we’re in a period where we think stock valuations are unattractive, we have no obligation to hold any — the same goes for bonds and cash.

How do you approach risk in general and in terms of specific areas such as emerging markets?

Our risk approach allows us to put together a portfolio with the primary goal of achieving strong risk-adjusted returns over the long term. In our benchmark-free strategy, we are not focused on trying to look good relative to a standard allocation of 60% stocks and 40% bonds or relative to competing managers, which can be a source of risk. What we are focused on is trying to avoid an inappropriate amount of absolute risk. This means our allocations are going to change over time.

When we’re thinking about investing in an individual emerging country, or emerging countries in general, we recognize that there are very significant risks there. We want to get paid for taking those risks.

One of the things we find attractive about emerging markets is that while almost any investments you make there come with risk, it’s not all the same kind of risk. For example, many emerging countries are associated with political risk, economic risk, legal risk or some combination of those three. Similarly the risks associated with companies headquartered in emerging nations tend to be different — a lack of rainfall may hurt a Brazilian utility, but likely will have no perceptible impact on a Korean industrial company.

 

The bottom line is that if emerging market stocks had the same expected return as developed market stocks, we’d prefer the developed market stocks. But if we’re getting paid a premium for taking the risks usually associated with emerging market stocks, we think it is appropriate to invest in them.

What are the pros and cons of your seven-year outlook, which seems long for the industry?

The basic benefit is that most asset classes are much more predictable on a longer-term time horizon than a shorter one. In the short run, returns are driven by news. Over longer periods we find that much of the day-to-day news cancels itself out and valuations matter far more.

Seven years is long enough that valuations can be extremely important drivers of returns. The basic downside of the longer outlook is that it requires more patience on the part of our clients.

PART TWO: Robert D. Arnott

Rob, tell us a little about your investment strategy.

We sometimes describe our investment strategy as a “three-pillar” approach. In other words, we have allocations in stock and bond funds — the first two pillars. We also invest in a third pillar, the alternative markets, which can offer diversification potential and a hedge against inflation. These kinds of investments might include treasury inflation-protected securities (TIPS), real estate investment trusts (REITs) and commodities, as well as emerging market stocks and bonds.

 

Some of these investments have been in a bear market since early 2013. Many investors might choose to avoid making allocations to these areas in a bear market, but that’s likely because they don’t know they’d be buying intense diversification away from their mainstream holdings.

How might that approach work over the long term?

In certain circumstances, your volatility may contract, your Sharpe ratio, which calculates returns against risks, may improve, and your beta may fall. This scenario can offer the potential for diversification with improved returns.

How might the strategy provide greater yield potential than traditional investments?

The traditional investment approach has served investors well over the last several decades — at least until recently. Thirty years ago, bond yields were in the double digits and stock yields were in the mid-single digits. Recently, however, both yields have come down into the 2% area.

While people’s expectations were often artificially bolstered by the tailwind of significant bull markets over the last 30 years, the starting point today is poor yields and poor long-term, forward-looking rates of return. It doesn’t mean we can’t have a bull market rising from current levels. It means that virtually the only way to do that is to have yields tumble far below where they are now. And they’re already in the bottom 10% by historical standards.

Therein lie the challenges. Forward-looking returns on mainstream stocks and bonds appear poor. And what allowed those yields to tumble, for the most part, was a disinflationary environment where inflation expectations went from the high-single digits 30 years ago to 1% and 2% today. Now, many investors we’ve spoken with say there’s no hint of inflation today. At the same time, few believe that there will be no inflation in the next 20 years or that inflation will announce its arrival in advance — allowing them to put their inflation hedges in place, and do so on the cheap.

We view traditional investing as a high price to pay to get only moderate returns. We think investors need diversifying markets that offer higher yields and higher growth rates — a third pillar in their portfolios that may fare well through inflation.  

These strategies are available on the U.S. Trust platform. To learn more, including their suitability for your portfolio, contact your U.S. Trust advisor.

Photograph of Ben Inker by Eric McNatt

Photograph of Robert Arnott by Ramona Rosales

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Some of the featured participants are not employees of U.S. Trust. The opinions and conclusions expressed are not necessarily those of U.S. Trust or its personnel. Any of their discussions concerning investments should not be considered a solicitation or recommendation by U.S. Trust and may not be profitable.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

Unlike conventional bonds, the principal or interest of inflation-linked securities is adjusted periodically to a specified rate of inflation. For example, the principal amount of Treasury Inflation-Protected Securities (TIPS) is adjusted periodically using the Consumer Price Index for all Urban Consumers (CPI-U). Inflation-linked securities of foreign issuers are generally indexed to the inflation rates in their respective economies.

Commodities Trading in commodities, such as gold, is speculative and can be extremely volatile. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments, unlike most other tangible investments.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.

Real estate investment trusts (REITs) involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.

International International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

For this issue’s Investment Spotlight, Capital Acumen’s editors spoke with two renowned money managers about investment strategy, risk and diversification.

PART ONE: BEN INKER

Ben, please describe some of the fundamentals of your investment approach.

The goal of our benchmark-free strategy is to generate returns of inflation plus 5% over the long term. We invest in stocks, bonds and other asset classes, including some liquid alternative strategies. We look for securities that are priced to give a decent risk-reward tradeoff, and all this is done without regard for a benchmark. We usually ignore assets that are not priced to deliver a decent return for the risk we’re taking. We have few limits on the number of stocks we can hold versus bonds or cash. Even so, it’s hard to imagine our being fully invested in only one asset class. If stocks were extraordinarily attractive relative to bonds and cash, we could conceive of going as high as 85% in stocks. On the other hand, if we’re in a period where we think stock valuations are unattractive, we have no obligation to hold any — the same goes for bonds and cash.

How do you approach risk in general and in terms of specific areas such as emerging markets?

Our risk approach allows us to put together a portfolio with the primary goal of achieving strong risk-adjusted returns over the long term. In our benchmark-free strategy, we are not focused on trying to look good relative to a standard allocation of 60% stocks and 40% bonds or relative to competing managers, which can be a source of risk. What we are focused on is trying to avoid an inappropriate amount of absolute risk. This means our allocations are going to change over time.

When we’re thinking about investing in an individual emerging country, or emerging countries in general, we recognize that there are very significant risks there. We want to get paid for taking those risks.

One of the things we find attractive about emerging markets is that while almost any investments you make there come with risk, it’s not all the same kind of risk. For example, many emerging countries are associated with political risk, economic risk, legal risk or some combination of those three. Similarly the risks associated with companies headquartered in emerging nations tend to be different — a lack of rainfall may hurt a Brazilian utility, but likely will have no perceptible impact on a Korean industrial company.

 

The bottom line is that if emerging market stocks had the same expected return as developed market stocks, we’d prefer the developed market stocks. But if we’re getting paid a premium for taking the risks usually associated with emerging market stocks, we think it is appropriate to invest in them.

What are the pros and cons of your seven-year outlook, which seems long for the industry?

The basic benefit is that most asset classes are much more predictable on a longer-term time horizon than a shorter one. In the short run, returns are driven by news. Over longer periods we find that much of the day-to-day news cancels itself out and valuations matter far more.

Seven years is long enough that valuations can be extremely important drivers of returns. The basic downside of the longer outlook is that it requires more patience on the part of our clients.

PART TWO: Robert D. Arnott

Rob, tell us a little about your investment strategy.

We sometimes describe our investment strategy as a “three-pillar” approach. In other words, we have allocations in stock and bond funds — the first two pillars. We also invest in a third pillar, the alternative markets, which can offer diversification potential and a hedge against inflation. These kinds of investments might include treasury inflation-protected securities (TIPS), real estate investment trusts (REITs) and commodities, as well as emerging market stocks and bonds.

 

Some of these investments have been in a bear market since early 2013. Many investors might choose to avoid making allocations to these areas in a bear market, but that’s likely because they don’t know they’d be buying intense diversification away from their mainstream holdings.

How might that approach work over the long term?

In certain circumstances, your volatility may contract, your Sharpe ratio, which calculates returns against risks, may improve, and your beta may fall. This scenario can offer the potential for diversification with improved returns.

How might the strategy provide greater yield potential than traditional investments?

The traditional investment approach has served investors well over the last several decades — at least until recently. Thirty years ago, bond yields were in the double digits and stock yields were in the mid-single digits. Recently, however, both yields have come down into the 2% area.

While people’s expectations were often artificially bolstered by the tailwind of significant bull markets over the last 30 years, the starting point today is poor yields and poor long-term, forward-looking rates of return. It doesn’t mean we can’t have a bull market rising from current levels. It means that virtually the only way to do that is to have yields tumble far below where they are now. And they’re already in the bottom 10% by historical standards.

Therein lie the challenges. Forward-looking returns on mainstream stocks and bonds appear poor. And what allowed those yields to tumble, for the most part, was a disinflationary environment where inflation expectations went from the high-single digits 30 years ago to 1% and 2% today. Now, many investors we’ve spoken with say there’s no hint of inflation today. At the same time, few believe that there will be no inflation in the next 20 years or that inflation will announce its arrival in advance — allowing them to put their inflation hedges in place, and do so on the cheap.

We view traditional investing as a high price to pay to get only moderate returns. We think investors need diversifying markets that offer higher yields and higher growth rates — a third pillar in their portfolios that may fare well through inflation.  

These strategies are available on the U.S. Trust platform. To learn more, including their suitability for your portfolio, contact your U.S. Trust advisor.

Photograph of Ben Inker by Eric McNatt

Photograph of Robert Arnott by Ramona Rosales

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Some of the featured participants are not employees of U.S. Trust. The opinions and conclusions expressed are not necessarily those of U.S. Trust or its personnel. Any of their discussions concerning investments should not be considered a solicitation or recommendation by U.S. Trust and may not be profitable.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

Unlike conventional bonds, the principal or interest of inflation-linked securities is adjusted periodically to a specified rate of inflation. For example, the principal amount of Treasury Inflation-Protected Securities (TIPS) is adjusted periodically using the Consumer Price Index for all Urban Consumers (CPI-U). Inflation-linked securities of foreign issuers are generally indexed to the inflation rates in their respective economies.

Commodities Trading in commodities, such as gold, is speculative and can be extremely volatile. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments, unlike most other tangible investments.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.

Real estate investment trusts (REITs) involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.

International International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.