NEWPORT BEACH, Calif. - Stocks are out. Alternatives are in.
In one the starkest pieces of evidence yet, PIMCO Funds has teamed up with First Quadrant Corp.'s Robert D. Arnott to run a tactical asset allocation fund of funds that invests in a broad array of conventional and alternative asset classes.
Reflecting a very negative view of public equity, the fund is invested primarily in government inflation-protected bonds, emerging markets debt and commodities. It launched July 1 as an institutional mutual fund called the All Asset Fund, with $5.5 million in seed money.
The alliance with Mr. Arnott marks the first time PIMCO Funds, a unit of bond giant Pacific Investment Management Co., has hired a subadviser. PIMCO officials said no other subadvisory arrangements are in the works.
The subadviser, Research Affiliates LLC, is a new firm established by Mr. Arnott last spring. Mr. Arnott is chief executive of the new firm and remains chairman of Pasadena, Calif.-based First Quadrant as well. He said First Quadrant's parent, Affiliated Managers Group Inc., Boston, blessed the formation of the new unit, as long as the new firm does not manage money and thus compete with First Quadrant.
Research Affiliates provides the tactical asset allocation model for the All Asset Fund, which invests in a dozen main underlying PIMCO mutual funds, with the opportunity to invest in 15 other PIMCO funds.
The fund represents the first time such a wide array of asset classes and subclasses is available in an asset allocation strategy, Mr. Arnott claimed. "From my perspective, I feel like a kid in a candy store, because for the first time I have the opportunity to use both conventional and unconventional assets."
At least one industry observer was intrigued by the concept.
Said Cynthia Steer, managing director, fixed-income research, for CRA RogersCasey, Darien, Conn.: "The venture is an interesting one between one of the best asset managers and one of the better minds in the business. From that perspective, plan sponsors are well-served to take a look at it."
Ms. Steer said this type of strategy will help pension funds and endowments and foundations help meet their return and payout targets in the current market. A new survey from Standard & Poor's shows 76.5% of U.S. defined benefits plans are below full funding, causing many to explore alternative investments.
Mr. Arnott argues the outlook for stocks is dismal for the foreseeable future. In a series of papers with a host of co-authors, he wrote the equity risk premium - the premium investors demand for taking stock risk over government bonds - might be negative or flat. A dividend yield of 1.5% plus 1% historical dividend growth provides a real return of 2.5% from stocks - the same amount now available from Treasury inflation-protection securities.
Plus, corporate earnings still are suspect; most companies do not expense stock options and do use high return assumptions for their pension funds, buoying the bottom line. Aggregate S&P 500 earnings may be overstated by 13% to 14%, he said. And he warns baby boomers will place further pressure on stocks as they head toward retirement age.
William H. Gross, PIMCO's high-profile chief investment officer, echoes those concerns. In a recent article, he warned the Dow Jones industrial average would have to sink to 5,000 from about 8,500 now to achieve a risk premium of 2.4%. The current market yield would need to more than double - to 3.5% - to approach fair value, he added.
"Stocks stink and will continue to do so until they're priced appropriately, probably somewhere around Dow 5,000, S&P 650 or Nasdaq God knows where," he wrote in an investment outlook available on PIMCO's website.
The All Asset Fund is designed to address such concerns. PIMCO officials are marketing the fund primarily to small and midsized institutional investors as a core holding, targeting expected returns of five to six percentage points above the Consumer Price Index, and low annualized volatility of around 6%.
The fund was up 5.5% in its first seven weeks, leading officials to think the strategy could beat its benchmark by eight percentage points or better. Like any tactical asset allocation product, it performs best in periods of high volatility, Mr. Arnott explained.
The strategy easily could be made available to larger institutional clients. "We expect institutional audiences to come on more quickly, particularly institutional audiences disgusted with negative returns," said Brent R. Harris, chairman of PIMCO Funds. "The investor wants not to own a portfolio of bonds or stocks but to build his purchasing power."
The All Asset Fund augments PIMCO's burgeoning selection of real return funds, which now totals more than $9 billion in assets. While the vast majority of those assets are invested in funds invested in TIPS, PIMCO has added various other real return strategies, such as a recently launched commodities fund. "People don't live by TIPS alone either," Mr. Harris said.
Hedge fund returns
What PIMCO and Mr. Arnott are offering investors essentially is hedge fund-type returns without the leverage and with lower-than-normal levels of volatility. Fees are capped at 85 basis points - a far cry from the 2% base fee and 20% performance fee charged by the typical hedge fund of funds. The prospectus for the new fund states Research Affiliates is paid 20 basis points for providing asset allocation advice.
Basically, the fund seeks to add value from three sources: from investing in alternatives when they are undervalued and conventional securities are overpriced; from PIMCO's strong-performing funds; and from asset allocation provided by Research Affiliates.
Currently, 45% of the All Asset Fund is invested in TIPS, 80% of which are long-duration TIPS. Also, 16% of the fund is invested in emerging-market debt, 12% in commodities, 9% long-term government bonds, 7% low duration fund, 6% in U.S. stocks, 3% in global bonds and 2% in mainstream U.S. bonds. No more than 50% of fund assets can be invested in any single fund.
The model curtly eschews exposure to high-yield bonds, U.S and European convertibles and Government National Mortgage Association securities because of the economy's fragile state and increased credit risk.
Exposure to domestic equity is through PIMCO's StocksPLUS funds, which use Standard & Poor's 500 index derivatives backed by portfolios of fixed-income securities. There is no exposure to international equities, although that's on Mr. Arnott's wish list.