As the lines between interest rate and credit risk become blurred, finding sources of āsafe spreadā becomes even more critical ā with investments based on traditional, broad sector classifications worthy of review (see Figure 2).
Implication #3 ā Rethink investment guidelines
In an uncertain economic environment, investors have a tendency to narrow their investment focus and gravitate toward tighter benchmark tracking and/or more passive strategies. At PIMCO, we believe more, not less, discretion is warranted when trying to navigate volatile global markets, avoid sectors affected by financial repression and hedge against inflation and/or adverse tail events.
In the aftermath of Lehman Brothersā collapse in 2008, for example, many investors moved aggressively to reduce risk and shunned everything from asset- and mortgage-backed securities to investment grade corporates, banks and financials, emerging markets, high yield ā basically anything that had credit or liquidity risk ā in favor of what were perceived as ābulletproofā government bond portfolios. This had several effects. First, many investors locked in losses to the extent they were forced to sell high-quality assets at low prices, missing the subsequent recovery. Second, many sold into an extremely illiquid market, further diminishing returns. And worse, many ended up in highly constrained, presumably ārisk-freeā government portfolios with index-like (or higher) positions in Greece, Portugal, Ireland and the other European peripherals that have since suffered from the eurozone debt crisis. While these investors had good intentions, their move to constrain portfolios worked to limit returns and actually exposed them to more concentrated investment risks.
In a period of rapid economic and market transformation, we believe investors can benefit from remaining flexible and permitting their managers sufficient scope around their benchmarks. This is of course subject to their underlying investment objectives and confidence in their investment managersā ability to manage risk. But we feel investors will generally be better served by giving their managers greater discretion to capitalize on potential opportunities, while avoiding sectors and securities that may be subject to financial repression, inflation and/or heightened tail risk. In formulating investment guidelines, more can be better than less.
Implication #4 ā Rethink approach to benchmarks
When I started at PIMCO 25 years ago, almost all of our clients used the same benchmark. Granted, most were U.S.-based pension funds, foundations and endowments, which had similar funded statuses, asset allocations and overall return objectives. They all pretty much used the same benchmark, similar one-page investment guidelines and the general objective of maximizing returns subject to risk. Times were far simpler back then, as today most of our institutional clients have 10- to 20-page guidelines with benchmarks covering every possible combination of market segments, countries, sectors and issuers.
But while the industry has clearly moved toward more bespoke, outcome-oriented benchmarks ā which we consider to be a positive trend ā most indexes are still backward-looking and reflect past patterns of market development. They are not necessarily structured to help investors seize opportunities created by the dramatic secular shifts taking place in the global economy, nor are they set up to avoid the pitfalls.
Consider the following scenario: Assume you are walking down the street with a pocket full of money and come across two people looking to secure a loan. The first says he has a mountain of debt, which is growing by the day; the second says she has a significant amount of income, which is also growing by the day. Who would you lend to? Hopefully borrower number two! Yet, when it comes to investing, most benchmarks will induce ā or, for passive investors, force ā you to go with the equivalent of candidate number one. This is because traditional indexes are market-weighted, which means the biggest allocations will be to those countries, sectors and issuers with the largest amounts of debt outstanding, with rising debt burdens and further debt issuance leading to ever-increasing allocations.
Take European bond investors, for example. Many have already suffered through downgrades of Greece, Ireland and Portugal, with growing concerns about Spain and Italy. Yet they may continue to suffer if they invest according to one of the traditional market-weighted European government bond benchmarks, as the indebted countries in the index continue to issue more and more debt and constitute an ever-increasing percentage of the benchmark. Global bond investors face a similar situation with traditional market-weighted global benchmarks, since there is a natural tendency to overweight large and growing debtors such as the U.S., Europe and Japan, rather than the stronger emerging economies that tend to have less debt and higher rates of income growth.
We recommend investors consider more forward-looking benchmarks and indexes as alternatives, to help ensure that lending/investing goes to those with growing income rather than growing debt.
Implication #5 ā Rethink asset allocation
Letās go back to the early to mid-2000s, when an increasing number of institutional and retail investors were adopting the Harvard and Yale models for their asset allocation. These were fairly aggressive models, with an emphasis on traditional equity, private equity, hedge funds and alternatives, and typically only a small allocation to long government bonds as a deflation hedge. While Harvard, Yale and many of the more sophisticated players probably knew what they were doing, when it came to understanding and preparing for the tail risk scenarios that did in fact hit in 2008, many others ā particularly those with shorter-term horizons and more immediate liquidity needs ā were caught by surprise as events unfolded. What happened? Quite simply, while their portfolios appeared to be very well-diversified on paper, they in fact had enormous equity factor risk as their different public equity components (U.S., non-U.S., large-cap, small-cap, value, growth), along with their private equity, hedge fund, alternative, commodity, real estate, high yield and emerging market bond allocations, all became highly correlated and sold off simultaneously. The pain was even more acute for the highly leveraged players who were even less equipped to handle the heightened volatility.
