At PIMCO, we have been advising clients for many years to look at underlying risk factor exposures rather than traditional asset class definitions (see Figure 3). And following the global market dislocation in 2008, we have had a growing number of clients ask us to review their existing allocations and subsequent diversification needs. It is amazing to us that portfolios that look fully diversified on a traditional asset class basis contain holdings that remain heavily correlated with total equity risk factor exposure ranging between 70% and 80%. Diversification is still as important as ever, but we believe investors need to look at risk factors rather than traditional asset classes when making asset allocation decisions.
Conclusions
As the economy undergoes important realignments, we believe the next few years will require investors to reconsider a number of conventional investment practices. Rethinking ārisk-freeā and ārisky,ā interest rate and credit risk, investment guidelines, investment benchmarks and asset allocation are all important considerations that should help investors better position their investment portfolios to meet the challenges ahead.
As your global investment authority, we hope to help you navigate the complex transformations over the secular horizon.
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āA ārisk freeā asset refers to an asset which has a certain future return. U.S. Treasuries are considered to be risk-free because they are backed by the U.S. government. All investments contain risk and may lose value.
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. 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. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. 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. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument. 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. Investing in derivatives could lose more than the amount invested.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. Since June 2007 the MSCI World Index consisted of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The index represents the unhedged performance of the constituent stocks, in US dollars. The Morgan Stanley Capital International Emerging Markets Index is an unmanaged index that measures equity market performance in the global emerging markets. As of May 2005, the Emerging Markets Index (float-adjusted market capitalization index) consisted of indices in 26 emerging countries: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey, and Venezuela. Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays Capital Global Aggregate (USD Hedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities.
The HRFI Fund of Funds index is an unmanaged index that invests with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The Cambridge Associates U.S. Private Equity Index is based on returns data representing nearly two-thirds of leveraged buyout, subordinated debt, and special-situations partnerships since 1986. The NCREIF (National Council of Real Estate Investment Fiduciaries) Property Index is a quarterly time series composite total rate of return measure of performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only. The Citigroup MLP (Master Limited Partnership) Index is an unmanaged index comprised of leading natural resource-related MLPs. The index is weighted on the basis of total market capitalization and is disseminated real-time on a price return basis, as well as daily on a total return basis. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Ā©2011, PIMCO.
