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never met him. He’s got heart, but as he’s probably joked a thousand times by now, it’s someone else’s; a 1996 transplant being the LOL explanation. He’s also got a lot of investment common sense, recognizing decades ago that investment managers in composite couldn’t outperform the market; in fact, their alpha would be negative after fees and transaction costs were factored in. His early business model at Vanguard promoting index funds was a mystery to me for at least a few of my beginning years at PIMCO. Why would most investors be content with just average performance, I wondered? The answer is certainly now obvious; an investor should want the highest performance for the least amount of risk, and for almost all measurable asset classes, index funds and many ETFs have done a better job than almost all active managers primarily because of lower fees. The “almost all” caveat is the reason I can write so freely and with such high praise for Vanguard. I am, after all, supposed to be promoting PIMCO in these Investment Outlooks, and PIMCO is a $2 trillion active manager with lots of long-term consistent alpha. Jack marvels about what he himself labeled in a recent Morningstar interview the “PIMCO effect.” To paraphrase his interview, he spoke to index managers beating almost all active managers, but then “there was the PIMCO effect.” We at PIMCO thank him for that with a “back atcha, Jack!” There’s actually a place for both of our firms and investment philosophies in this age of high finance. If Bogle’s concept of indexing was metaphorically similar to finding a cure for the cancerous devastation of high fees, then perhaps PIMCO’s approach could be similar to mapping the investment genome and using it to produce consistently high alpha. There’s room for each of these investment laboratories. I will admit that there are other active management labs as well that are worthy of not only recognition, but investor confidence and dollars. I have nothing but the highest of praise for Bridgewater’s Ray Dalio and GMO’s Jeremy Grantham and their staffs. Their voluminous thoughts occupy a special corner of my desk library. Each has a distinctly different approach to active management – Dalio’s focusing on a levering/delevering template and Grantham’s on a historical reversion to the mean for most asset classes. Neither Vanguard, PIMCO, Bridgewater nor GMO, however, has discovered a cure for the common cold. Our performance periodically, and sometimes for frustrating long stretches, stuffs our noses or aches our heads, and makes us wonder why we hadn’t been more careful about washing our hands during flu season. Our firms make mistakes, even if, in Vanguard’s case, it’s the indexed mantra of being fully invested in an overvalued market. Where might our future mistakes be hiding? What keeps us up at night? Well I can’t speak for the others, having spoken too much already to please PIMCO’s marketing specialists, but I will give you some thoughts about what keeps Mohamed and me up at night. Mohamed, the creator of the “New Normal” characterization of our post-Lehman global economy, now focuses on the possibility of a” T junction” investment future where markets approach a time-uncertain inflection point, and then head either bubbly right or bubble-popping left due to the negative aspects of fiscal and monetary policies in a highly levered world. We are both in agreement on the perilous future potential of market movements. Mohamed’s T, I believe, was meant to be more descriptive than literal, and is a concept, like the New Normal, that may gain acceptance over the next few months or years. But aside from a financial nuclear bomb à la Lehman Brothers, our actual scenario is
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Page 2 ©Advisor Perspectives. and interest rates came back down. The standard “three musketeers” menu for retail investors has always been 1) investment grade and 2) high yield bonds as well as 3) stocks. The Fed. But investors are all playing the same dangerous game that depends on a near perpetual policy of cheap financing and artificially low interest rates in a desperate gamble to promote growth. “Get used to negative real interest rates. but also an increase in redemptions in retail mutual fund space. Others. my point about the gradual as opposed to sudden disillusioning of investors worldwide is just that. All of the above 1-6. even with zero-bound yields and QE.” their policies insinuate. and so for them there appears to be an increasing array of higher return alternatives. basically telling investors that they have no alternative than to invest in riskier assets or to lever high quality assets. perhaps a winged eagle signifying something more gradually sloping left or right. were only mildly discouraged and continued their faith-based. But then the Fed recognized the negative aspects of “financial conditions. This year’s April taper talk by the Federal Reserve is perhaps a good example of this forward path of asset returns. capital gain dependent investments despite what should be the obvious conclusion that QE and low interest rates were as critical to their market as they were to bonds. which speaks more to desperation than logical thinking. borrowing at 10-50 basis points in overnight repo and investing at higher rates of return despite their artificiality. contain artificially priced assets based on artificially low interest rates. June and July after 10-year Treasuries had bottomed at 1. such as many alternative assets. the BOJ (certainly). Some are unlevered. however. our actual scenario is likely to play out more gradually as private markets realize that the policy Kings/Queens have no clothes and as investors gradually vacate historical asset classes in recognition of insufficient returns relative to increasing risk. But aside from a financial nuclear bomb à la Lehman Brothers. Stock investors. 5) hedge funds and 6) unconstrained space. however.few months or years. like Treasury bonds. the ECB and the BOE are setting the example for global markets. Admittedly the reaction in the bond market was rather sudden and it precipitated not only the disillusioning of bond holders. however. Sort of a reverse “Sisyphus” moment – two steps upward.65%. The actual T might in reality be shaped something like this: . Yet this now near 5-year migration across the global asset plains in search of taller grass and deeper water has had limits. astute investors might move away from traditional risk such as duration as opposed to towards it. than a T. Investors now await nervously for news on the real economy as well as the medicine thatJanet Yellen will apply to it. That medicine. will most assuredly include negative real interest rates that at some point will give bond and stock investors pause as to the continued potency of historical total return policies generated primarily by capital gains.” postponed the taper. Bridgewater and GMO – will begin to prefer the comforts of a less riskoriented migration.” they seem to command. Deep in the bowels of central banks research staffs must lay the unmodelable fear that zero-bound interest rates supporting Dow 16. Well. one step back as it applies to yields and more of a . move out on the risk spectrum and in the process help heal the real economy. If they cannot smell the distant water or sense a taller strand of Serengeti grass. . but nonetheless priced too high by the Fed in an effort to encourage migration to riskier bonds and/or asset classes. both in price and real growth space. In recent years. All rights reserved. institutional investors have gravitated into 4) alternative assets. then investors at the margin – astute active investors like PIMCO.000 stock prices will slowly lose momentum after the real economy fails to reach orbit. depend on the levering of portfolios themselves. Inc. “What other choice do we have?” has become the mantra of stock investors globally. If monetary and fiscal policies cannot produce the real growth that markets are priced for (and they have not). Bond investors found that out in May. “You have no other choice.
All rights reserved. subject to early repayment risk. . it is a policy that a Janet Yellen Fed seems determined to pursue. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. that this portfolio construct is dependent on the eagle’s wings as opposed to the junction of a T. experience a haircut. While this and its conjoined policy of QE may have only redistributed wealth as opposed to creating it (picking savers’ pockets while recapitalizing banks and the wealthiest 1% of our population).” In it. but the 25 basis point policy rate will continue until 6. This we have done. credit and inflation risk. Mortg age. but the unwinding may occur gradually. Sovereign securities are generally backed by the issuing government. Investing in the bond market is subject to certain risks.0% inflation at a minimum have been achieved. but are generally not backed by the full faith of the U.and asset-backed securities may be sensitive to changes in interest rates. then a traditional bond fund should underweight duration and perhaps overweight other carry alternatives such as volatility. interest rate. and flush confident investors from the comfort of this Great Moderation Part II. however. We at PIMCO will prepare for that day while hopefully consistently beating Vanguard along the way. issuer. front-end Treasury. curve and credit. corporate and mortgage positions should provide low but attractively defensive returns. The taper will lead to the elimination of QE at some point in 2014. Eagle’s Speed Read 1) Be confident in the “PIMCO effect.” as Jack Bogle calls it.S. 2) Look for constant policy rates until at least 2016.5% unemployment and 2. Think William H.S. Obligations of U. volatility and curve steepening positions. Front-end load portfolios. Inc. Overlevered economies and their financial markets must at some point pay a price. with the aim of outperforming Vanguard as well as many other active managers. I suggested that if the Fed and other central banks had artificially lowered yields and elevated bond prices. that the Fed will hold policy rates stable until 2016 or beyond. Our primary thrust has been to focus on what we are most (although not totally) confident about. including market. and their value may fluctuate in Page 3 ©Advisor Perspectives. There is no doubt. Don’t fight central banks. If so. I suggested that bonds and bond portfolios contain a number of inherent “carry” risks and that duration/maturity was but one of them. 3) Global economies and their artificially priced markets are increasingly at risk. The “PIMCO effect. Gross Managing Director ! Past performance is not a guarantee or a reliable indicator of future results .In gradually moving away from traditional risk assets. is alive and well in 2013. We have positioned our bond wars portfolio – heavily front-end maturity loaded along with credit. I again refer to my August Investment Outlook called “Bond Wars. investments may be worth more or less than the original cost when redeemed. government agencies and authorities are supported by varying degrees. government. and our relative performance reflects it. but be afraid.” as Jack Bogle calls it.
Investors should consult their investment professional prior to making an investment decision. while generally supported by some form of government or private guarantee. especially during periods of downturn in the market. there is no assurance that private guarantors will meet their obligations.P.pimco. in the United States and throughout the world. 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. . respectively. Inc. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L. All rights reserved. This material is distributed for informational purposes only. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. strategy or investment product. or referred to in any other publication. (c) PIMCO www. Information contained herein has been obtained from sources believed to be reliable.response to the market’s perception of issuer creditworthiness.com Page 4 ©Advisor Perspectives. PIMCO. ©2013. and Pacific Investment Management Company LLC. and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security. but not guaranteed. No part of this article may be reproduced in any form. estimates. without express written permission. Forecasts.