July 18, 2019
Justin Blesy: Thank you for joining us for today's master class on portfolio construction. My name is Justin Blesy and I'm an asset allocation strategist here at PIMCO. We have a fantastic panel here today to discuss today's topic, which is timely given the multiple challenges facing asset allocators in the current market environment, including many advisors we speak with on a daily basis.
Most thoughtful approaches to asset allocation focus on the road ahead, both identifying opportunities and managing risks. And while the strong returns many clients have experienced since the depth of the crisis are a positive looking back, looking forward, the potential for increased volatility, increased asset class dispersion, rising interest rates, and generally full valuations make the road ahead particularly challenging.
On top of this, there's a shift underway in terms of the way advisors and home offices are approaching asset allocation, especially as advisors are spending more and more time on things like financial planning, charitable giving, estate planning, and tax management, and increasingly focused on delivering outcomes, rather than simply beating benchmarks for their clients.
Joining me today to explore these topics are Mary Hoppe, a senior vice president and account manager based in Boston, Massachusetts. She has 28 years of experience working with advisors on their investment challenges, and will provide her firsthand experience of the portfolio construction evolution we see ongoing today.
Mark Thomas, an executive vice president and head of PIMCO's managed account business based in Newport Beach, California. Mark has worked closely for many years with home office teams and established and emerging platforms, and will provide his insight on trends related to model portfolio delivery and access.
And finally, Steve Sapra, an executive vice president and member of PIMCO's client solutions and analytics team. Steve is a lead member of our port—model portfolio team, working to create the overall framework, as well as overseeing regular updates to our model allocations as market conditions and PIMCO's investment views change.
We plan to focus today's discussion primarily around three topics. First, the current market environment, investment challenges and industry trends. Second, PIMCO's approach to portfolio construction. And finally, the road ahead, how we see things evolving going forward.
Mary, we'll start with you. What are some of the biggest portfolio construction challenges facing advisors today?
Mary Kralis Hoppe: Well, Justin, you highlighted a few. Advisors have a really tough job today. Everything is just more complicated. First of all, they're — the investing environment is certainly more complicated with yield spreads the tightest they've ever been, and valuations are very high. Most really good advisors know the road signs call for caution.
Second, their clients' lives have gotten a whole lot more complicated. Most clients came to these advisors when they were accumulating their wealth, and now most of their best clients are either in retirement or on the cusp of retirement.
And so, there has got to be a lot more attention to financial planning needs, things like wealth distribution, wealth transfer, creating an income stream, all at a time when the, uh, the investing environment is tricky, right?
And then finally, third, uh, the regulatory environment is so much more complicated too, and that's requiring a lot more of the advisor's time, uh, to address compliance duties. And so all that, add all that together and it makes a really hard job for advisors because they still have the same 24 hours in a day.
Justin Blesy: And Mark, similar question to you, but time from the perspective of the home office.
Yeah, thanks Justin. As Mary mentioned, you know, things keep getting more complex. I think about, you know, 20 years ago when you used to have a Rolodex of phone numbers in your head, and now you have a cell phone that does all of the, the memory of it. Now, now I only remember two phone numbers, my wife's and mine. But it doesn't mean I'm doing less; it means I'm doing more.
And that's what financial advisors in the home offices have to deal with. As you mentioned, planning, tax considerations, working with lawyers, all of this becomes a more complex solution as you deal with, now, clients going through and into retirement. So, the idea of outsourcing more of their business to focus on those core competencies becomes more and more important, and more popular as, uh, as the business evolves.
Justin Blesy: And Steve, you know, maybe just purely from an investment perspective, we've had such strong returns since the depth of the crisis, so why does it really feel tough to be an asset allocator today?
Steve Sapra:Well, Justin, the fact that, uh, returns have been so strong since 2009 is, in fact, precisely why, uh, why asset allocation is challenging today
A combinative central bank policy, uh, has largely come to an end, and that means that asset classes are likely to face, uh, headwinds going forward. You know, asset allocation is never easy, but, but it's particularly difficult today.
In order to do asset allocation successfully, one of the first things you need to do is you need to have expected returns that are grounded in the reality of today's, uh, lower-returning world. Uh, equity multiples are high today by historical standards. Interest rates are low.
As Mary mentioned, credit spreads are relatively tight. And that means that returns going forward [clears throat], almost by definition, have to be lower.
Uh, realistic return assumptions just simply must reflect these facts. Uh, and that isn't enough. In addition to having, uh, well-defined expected returns, we need to have estimates of risk and we need to know how much, uh, expected returns, given our views, uh, will be, uh, will be rewarded for the amount of risk investors need to take.
Uh, one of the common ways that investors measure this trade-off is the concept of the Sharpe ratio, which measures an asset class' expected return over cash divided by its volatility. And, as a general statement, Sharpe ratios today are compressed because valuations are high. But in constructing portfolios in general, we would want to emphasize asset classes that have relatively higher Sharpe ratios while de-emphasizing those that have relatively low Sharpe ratios.
Justin Blesy: So, Steve, we heard, uh, from both Mary and Mark that, uh, asset allocation is an area where advisors are seeking, you know, more, uh, guidance in outside perspectives. So, when you think about PIMCO's approach, can you maybe, uh, give us the basics in terms of where to start?
Steve Sapra: Sure. Well, portfolio construction always starts with, with the objectives. Uh, is the portfolio designed to generate a high level of income? Uh, is it designed to be conservatively positioned and perhaps insulating the investor from, say, movements in interest rate risks? Should it have equities, uh, which arguably can provide higher expected return? This is really the starting point of any portfolio construction process. What is it that we're actually trying to achieve?
Uh, once we've, once we've decided what the objectives are of the portfolio, the next step is to say, "Okay, well what are the investment types that are reflective of that objective?" Uh, in other words, what is the investible universe going to be?
Uh, and it doesn't necessarily mean that, that every fund or every asset needs to be perfectly reflective of the objective. But at the end of the day, when the portfolio combines different strategies and different funds, we want that combination to be reflective of the overall, uh, of the overall objective. This is a critical part of the process. It's definitely part art and part science, but we want, we want ultimately the, the fund universe to reflect the objective of, of the portfolio.
Uh, the next step is to define guard rails. [clears throat] So we don't want any particular investment to contribute too much to risk. Uh, we want to make sure that the, the funds which are allocated to in the largest proportion are the most reflective of the underlying objectives. Uh, and this is a critical part of, of the portfolio construction process.
Ultimately, at the end of the day, uh, the optimal portfolio that we want to deliver has the highest expected return possible, uh, within the confines and constraints of the portfolio's objectives.
Justin Blesy: And Mary, maybe turning to you, how does that initial structuring that Steve mentioned, uh, align with the way you see advisors starting the portfolio construction process?
Mary: It, it actually aligns really, really well, but, uh, the vocabulary is very different. Uh, and so, for example, uh, it's not about, "Do I need an income?" It's, "I'm about to retire. How can I get an income stream? I want to put my kids through college. How am I going to make that happen? I need, uh, long-term needs. How does that happen?"
And, uh, so advisors have come a real long way of, of moving the conversation from one of investments to one of outcomes. And that involves really engaging in a financial planning conversation with a client, uh, and really addressing much more holistic, uh, holistic outcomes.
So again, the whole language changes from market returns to getting that outcome met. And, and what we see is the language changes into family benchmarks, not market benchmarks. And what that does is it serves to keep the client focused on the things that are important, as opposed to what they're hearing on the television and some amorphous benchmark that doesn't have any relevance to the things they're trying to accomplish.
Justin Blesy: So, Mark, you know, Mary mentioned this shift towards outcomes, which makes a lot of sense, uh, at a high level. Uh, but the traditional focus is typically on benchmarks and beating benchmarks. So, how do you see home offices grappling with, uh, that dichotomy?
Mark: Yeah. I mean, it's definitely a big challenge. If you think about, you know, go back to the '80s, when the commercials would be, you know, when EF Hutton talks, people listen. Now it's much more client-driven, uh, objective that advisors and their home offices have. But they're doing that, and they're making this shift from a benchmark-oriented approach.
You know, benchmarks are, are easier to manage. It's easier to look at managers versus benchmarks to focus on managers that fit into certain style boxes. So, it becomes, uh, challenging for the analysts that recommend the strategies, the home offices that build the platforms to think about, "How do I construct a portfolio of outcome-oriented solutions to help address a client's needs, to address that family benchmark, that family objective that the, uh, that the advisor's trying to meet today?"
What we see is really use of, now, analytic tools to help do that. And Steve will talk more about this, but tools that help understand where risk is coming from in a portfolio, how portfolios can interplay with each other, and what they'll do in various market environments.
That's, uh, that's really where, you know, today, we're spending a lot of times with advisors, and there's advisors spending time with their clients to understand the trade-offs that they're taking, the risks, and to employ solutions rather than just alpha-oriented strategies versus a benchmark to construct a portfolio.
Justin Blesy: That's helpful. So, we've, we've talked a little bit about the starting point, the objectives and the guard rails. Uh, Steve, I know you mentioned sort of the next part of the process focuses on return expectations. And at PIMCO, we have a whole process behind this, called our capital market assumptions. Uh, so maybe you could give us a little bit more insight into that process.
Steve Sapra: Sure, Justin. Well, well the term process is really, is really the key here. Uh, and while every firm or investor will have their particular process or way of coming up with expected returns, uh, at PIMCO, the way we do this is, is we set long-term expectations for key risk factors, things like interest rates, credit spreads, foreign exchange, et cetera. And this all starts with our cyclical and secular forum process.
Our cyclical forum process takes place three times a year, and this is where we form our views on, uh, where things are headed over, say, the next 12 months. And our, our secular forum takes place once a year, and that's where we set our longer-term views, say for the next, next three to five years.
Uh, and importantly, because, uh, asset classes are simply carriers of factor risk — for example, you can think of the Barclays US Aggregate Index, sort of the key core bond index in the US, as a carrier of duration risk and mortgage risk and corporate bond risk and so on and so forth.
When we have views on those underlying risk factors, it automatically implies a view on, on the asset class itself. And one of the major advantages of doing things at the risk factor level is that it virtually ensures consistency across indices and asset classes. So, for example, to the extent different types of bond indices have exposure to the duration factor, to the extent we have of you on the duration factor, it will be reflected in all of those indices and in an identical way.
Justin Blesy: Thanks, Steve. You know, Mary, turning to you, we've talked a little bit about, uh, this lower return environment, right? Mid-single-digit potential for stocks, low-single-digit potential for bonds. Uh, how do you see advisors grappling with those new realities, and importantly, uh, setting client expectations?
Mary Kralis Hoppe: Yeah. You've touched on the thing that probably keeps most advisors up at night. Everywhere they turn, they're being told to expect lower returns across the board. How they're handling those client conversations, though, is a mixed bag.
The best advisors I work with really stick to that financial plan and use that financial plan as the centerpiece of the client relationship. It's not a one-and-done. It's a living, breathing document that constantly gets updated based upon things like lower return expectations or a client's life changes. And this allows the advisor to really stress test the portfolios, and are they going to work amid these lower return expectations?
Now, a lot of clients with significant wealth might be able to weather that really well, but a lot of clients may not. And that is what results in some challenging conversations. Clients might need to, you know, work longer, spend less in retirement, leave less to their heirs. These are conversations that can be, in fact, very difficult, but better to have them on the front end, uh, using that financial plan, so that they can model where they can make rational changes and have rational conversations.
But here's the rub. All that takes time. All that takes resources. And financial advisors don't have much more time. And, of course, they can add resources. They can add staff. But that's a challenge too amidst a world where fees are constantly getting compressed and one has to really think long and hard about making such investments.
Mark Thomas: Yeah. It's definitely, from a home office, I think about enabling advisors to help pl—provide those planning tools, help facilitate those conversations, help deliver material and information that helps a client understand those objectives, where they're to accomplish for, for their goals over time.
Justin Blesy: And maybe to dive a little bit deeper into this, Steve, you mentioned our risk factor approach to investing. Can you elaborate on what you mean by that?
Steve Sapra:Sure. Well, think about the, uh, think about the fixed income space and the number of indices that are in the fixed income space. You have. You have treasury indices. You have corporate bond indices. You have high-yield indices. You have indices that focus more on mortgages. You obviously have domestic. You have global, uh, global indices.
But what's really key is that all of these different indices are only exposed to a handful of what we call risk factors — in other words, the primary drivers of risk and return. Uh, so for example, uh, all of the benchmarks that I just mentioned have exposure in varying degrees to the duration risk factor. So, there's a common element that permeates across the entire, entire space.
[clears throat] Now, in terms of, in terms of forming expected returns, think if one were to try and come up with expected returns for all the different types of bond indices in the universe. How, how likely do you think it would be that there would be a consistency in the underlying factor views associated with that? It would essentially be zero. There's almost no chance.
But think about if you started at the risk factor level, like we do at PIMCO, if you start at the ground up by forming views on duration and credit and mortgage and so on and so forth, and then roll that up to the asset class level. Uh, what that does is it virtually ensures consistency across the entire fixed income space.
So, and this is because there's a one-to-one translation between risk factors and asset classes. It doesn't go the other way. It goes from risk factors to asset classes, not from asset classes to risk factors. So, one must start at the risk factor level to ensure that asset class views are, are consistent.
Justin Blesy: And that's helpful on the return side, but another use for risk factors is to build a lot more intuition on the risk side as well. You could look at, you know, simple asset class volatilities and simple asset class correlations. Uh, but you mentioned a few risk factors there, things like duration and, you know, equity beta or equity risk. Maybe using those as an example, can you, uh, elaborate a bit on how we use risk factors on the risk side of the equation?
Steve Sapra: Sure. Well, one of the, one of the most important considerations in portfolio construction is this relationship between the duration factor, which is effectively exposure to high quality sovereign bonds, typically, typically US government bonds, uh, and how the returns to that risk factor relate to things like credit and equity and so on and so forth. Uh, and over the past 20 plus years, it's primarily been the case that that correlation has been quite negative.
What that means in general, uh, is that when equity markets sell off or when, when there's an adverse movement in the credit market, exposure to high-quality duration has sort of been there as a hedge, to some degree. Not always, but largely it's been there as a hedge to offset some of that risk.
And [clears throat] the implication of that, then, is that balancing duration and credit or duration and equity in, say, an asset allocation portfolio, uh, can significantly improve the portfolio's efficiency. Uh, but how do you do that, right? It's not easy. The types of things that I'm talking about are actually fairly involved and require a reasonably high degree of, of complexity and sophistication. Uh, [clears throat] and that's why you really need a well-developed portfolio construction process in order to sort of measure these trade-offs.
Justin Blesy: And you know, Mark, we, uh, we run a lot of portfolio analyses for advisors, basically taking their portfolio and running through this risk factor lens.
Mark Thomas: Yeah.
Justin Blesy: What are some of the key takeaways we consistently come back to when running those analyses with advisors?
Mark Thomas: Yeah. I mean, we run hundreds of these a year for, for advisors. As we talked about earlier, to try and get a sense of how your portfolio looks in a world where you're focused on outcomes versus betas or benchmarks, uh, becomes really helpful for them.
So what we tend to see and what tends to be a little bit surprising for the advisors is, is really on the fixed income side. Uh, really, the, the focus usually is that they want to think about the risk level that they're taking, as Steve mentioned, in their portfolio. But then, what are the risks that they're taking?
So, we tend to find that a lot of portfolios have about a risk level of the Barclays Aggregate Index, sort of a broadly used, uh, index that advisors measure their fixed income portfolios, again. But where those risks are being taken becomes really where the interesting conversation is.
So again, their overall risk level will be similar to that of the Barclays Ag, but what we tend to find, given where markets have been and what's been performing, is allocations to high yield, allocations to investment-grade credit, risk factors, that bring in risk factors that may not deliver the kind of correlation benefits that the advisor wants when they're investing in fixed income.
So that tends to be probably the most eye-opening, uh, thing that advisors are finding, is that, over time, given the returns of those asset classes, given the reduction and volatility of those assets, or even just the lack of rebalancing out of strength and into weakness, that they're over-allocated into riskier parts of the fixed income market. It's commonly where advisors are positioned.
Mary Kralis Hoppe: You know, Mark, I totally agree with you. The, uh, the advisors that I work with who have done these studies are always reminded of—that asset allocation is the fuel to the financial planning engine. And a good asset allocation should essentially make that engine most—more efficient.
And while they put things together with a great collection of great managers with past performance and they're well-diversified from a sector pie chart standpoint, they are very surprised when they look at it through the risk factor lens that, "Uh-oh, maybe I'm not as diversified as I thought I was."
Mark Thomas: Yeah.
Mary Kralis Hoppe: And here we are, after ten years of zero-bound rates and a great equity market, advisors really struggling and scrubbing portfolios to make sure they didn't miss something. And so, that's why this risk factor approach has been a real eye-opener for a lot of the clients we work with. It's not a language they've ever spoken.
Mark Thomas: Right.
Mary Kralis Hoppe: Uh, so that's been valuable.
Mark Thomas: Yeah. We, we, we often do shock analysis. Sometimes the outcome is a shock for the advisor, but that's not why it's called shocks. But we'll do a number of, uh, tests of different, you know, market environments, 2008 financial crisis, other things that have happened in the marketplace to see how their portfolios will react. And that's where you really get to see, "Is this portfolio doing what it's intended to do for the overall, for the overall client's portfolio? Is it zigging when other things should be zagging?"
And that's, that's quite eye-opening for advisors, as they have these assets in the portfolio for that reason. And when the behavior isn't the way that they expect it in those market crises, or in events that they think may happen in the future, it becomes a real eye-opening experience for them.
Mary Kralis Hoppe: Especially the behavioral finance challenges that a lot of advisors are dealing with. Think about it. We've had great markets. And many clients are asking, "How come I'm not keeping up with the S&P 500?" Well, and they say, "Look at your diversified portfolio. When things go sour, this diversification should help you out."
And what they're finding is maybe that's not so much the case, that they have to be really careful about making sure that diversification promise actually does, in fact, deliver.
Justin Blesy:Yeah. And these are really good points because the last piece of the puzzle is kind of stress testing the overall portfolio. And in the last five years, we've had, you know, very low volatility environment. It can be — You can almost be lulled into sleep about forgetting about the potential downside of these portfolios.
So, so Steve, maybe to start us off, how do we think about kind of building in, uh, some of these stress scenarios into the way we construct portfolios?
Steve Sapra: Uh, well, one thing maybe I'll address first is, is complacency, and this sort of gets to some of the kind of behavioral issues that Mary, Mary was alluding to.
You know, if you look at kind of what market volatility has been like for the last five or so years, it's actually been relatively low, certainly low by, by historical standards. And this is exactly the type of environment where investors can get complacent. You know, "Why am I not keeping up with the S&P 500?" You know, "Maybe I need to take more risk."
Uh, and this is why we utilize, actually, very long-term volatilities, 20-plus-year volatilities when we construct, uh, when we construct our model portfolios. Uh, if you think about the last 20 years, there's a lot of stress periods in there. Obviously, everyone is familiar with 2008. There was a recession in 2001. There was the Asian financial crisis, the Russian financial crisis, the dot com bubble. There's been a number of stress periods.
And so, when you, when you build portfolios based upon long-run volatilities, typically you get more conservative portfolios, uh, given the objective.
In terms of stress testing, this is another way to look at risk. You know, sort of the traditional academic way is standard deviation. But, but there's obviously other ways to look at risk too, and one of those is stress testing. And stress testing entails decomposing the portfolio into its constituent risk factors and seeing how those risk factors would have performed in historical stress periods, say the 2008 financial crisis, uh, maybe the 2013 taper tantrum when interest rose—interest rates rose dramatically, uh, during the second half of 2013.
So you want to look at risk, uh, in multiple ways, not just things like standard deviation or volatility, which most people do, but also get some idea about how the portfolio would be expected to perform under kind of different historical stress periods.
Justin Blesy: Maybe, uh, maybe for Mary and Mark — You know, and Mark, you mentioned it was a shock to clients — but what do you do with that information once you have it and you see what the portfolio could do in these different market environments?
Mark Thomas: Yeah. I mean, you know, quite often it's a pretty eye-opening experience for advisors when they see it. And really, then, how do you communicate that appropriately to your client? Uh, so again, the home offices are trying to provide both the tools and then the, the mechanisms to allow for that, to facilitate that conversation. Is it an adjustment in the allocation? Is it thinking about their withdrawal rates differently? Is it thinking about tax management or planning a little bit differently?
So there's a lot of, uh, conversations that really jump off. As, as Mary sort of mentioned, it really starts with that plan. And it's always, if your home base is that financial plan, then you can adjust the portfolio, you can change in and out of strategies, you can outsource to solution providers much easier because, again, the objective is trying to meet the plan and the goals of the, of the client's plan.
Mary Kralis Hoppe:And that modeling also helps train the client. Uh, most of these home offices have, have equipped their advisors with some really good, uh, financial planning software that employs stochastic modeling.
And so, the conversation becomes, "What does this portfolio behave like through sustained great markets or sustained bad markets or normal markets?" And advisors, the good ones I work with, really hone in on those sustained bear markets. And can we still meet the goal? What is the probability of success if your portfolio had to endure these sustained down markets?
And so, if the answer is yes, great. But when those things happen, the, the traditional emotions come through, but the advisor can go back and say, "Remember, we had this conversation, and look, everything's still on course, stay the course."
So the financial planning modeling is the science, but the art — and this is where advisors do, in fact, earn their fees — the art is holding the hands of the client even with the numbers in front of them that say, "You're going to be okay." And advisors are getting much better at training clients.
I just did a panel of advisors this week about that, and the market was very volatile. The question from the audience was, "Your phone must be ringing off the hook because of the crazy markets." And every advisor on the panel said, "No, not at all. We've trained our clients to expect this. Their plans can ride through it. And it's one day of volatility. And if that one day turns into one week, we might get one or two phone calls."
So, it's been an interesting engagement to watch advisors really evolve their way they do business with clients.
Justin Blesy: So, I think, as a panel, we've done a nice job of making this seem easy in terms of the overall process. But there is actually some additional complications and unique situations that, uh, you know, each client has. Maybe we'll take a few of those in turn.
Uh, the first is taxes. You know, for higher net worth individuals, that's a really important input to the overall process. So, Steve, how do we take into account taxes in the portfolio construction process?
Steve Sapra: So Justin, as you note, uh, taxes can take a significant hit out of returns, particularly for high net worth individuals.
And if you think about fixed income, most of, uh, most investors are taxed at their federal plus state marginal tax rates, which can eat substantially into overall returns.
So, uh, so one, one obvious way to, to help alleviate this, at least to some degree, is to introduce municipal bonds into the portfolio. Obviously municipal bonds have a high degree of, of tax efficiency. But unfortunately, it's not as simple as just taking part of the portfolio, say 40%, and swapping it for some munis. Uh, and the reason that is is that, often times, municipals have very different properties and behave very different than the underlying portfolio. So, if you just take a, quote unquote, pro rata slice and swap it for munis, you probably will end up significantly changing the characteristics of the portfolio, which obviously is undesirable.
So, to address this issue, we've developed a process whereby we, uh, we can allocate a significant portion of the portfolio to munis, but do so in such a way, uh, that keeps the underlying characteristics and objective intact. Uh, and we do that by making sure that the duration is largely in line and that the credit quality is largely in line.
Uh, and at the end of the day, these portfolios have the same overall objective as the underlying taxable portfolio, but, but do so in a much more tax efficient way.
Justin Blesy: that's PIMCO's approach. For Mary and Mark, how do you see advisors tackling this challenge?
Mary Kralis Hoppe: What I see from advisors is they've never really had to think much about, uh, the, the tax efficiency of their portfolios. For their high net worth clients, it was, "I'll put taxable bonds in the IRA money and I'll put munis in the taxable accounts."
But some things have changed that are requiring advisors to think differently on that approach. Uh, first of all, it's the first time in many, many years we're facing a rising rate environment, so now duration management actually means a whole lot more. Second, given that most clients, their best clients, that is, are now starting to draw income from portfolios, and having been in such a low-yield environment requires that they look elsewhere to find yields that are a little higher than what high-quality munis can offer.
And then, finally, this tax regime has changed significantly, and a lot of it, uh, a lot of clients are really going to have a complicated tax picture. And so, those three things together require advisors to think very differently about mixing municipals with taxable bonds to strike that balance between income, interest rate risk, and tax efficiency.
Justin Blesy: So, we talked a little bit about building blocks there with the municipal bonds versus taxable bonds. Uh, another conversation on building blocks is the active versus passive debate ongoing in the industry. And obviously, here at PIMCO, we're big believers in active management, particularly for fixed income. Uh, Steve, would you be able to elaborate a little bit on, you know, why this is and why we think, uh, active management in fixed income really does work?
Steve Sapra:Sure, uh, happy to do that.
So, so William Sharpe, the Nobel laureate, taught us a number of years ago that, uh, the average active manager should underperform their benchmark by the amount of their fees and their transactions cost. And it's been sort of well-documented in the equity space that equity managers, on average, underperform. Uh, and in a recent paper we put out, we found out that, uh, only 43% of active equity managers actually outperform their benchmarks over a ten-year window. But in the fixed income space, 81% of managers outperform.
So, why this discrepancy? Uh, well there's a number of reasons, but one of the main reasons we think is the presence of what we call non-economic or quasi-economic investors in the fixed income world. So, what do we mean by this? We mean that the fixed income world has—is dominated by investors who are less price-sensitive than in the equity world.
So, think, for example, of central banks. Central banks, since the, since the 2008 credit crisis have been buying bonds, uh, in Japan, in the US, uh, and, and they do this in a price-insensitive way. They do this irrespective of price.
Uh, you think about the role of insurance companies in the fixed income space. They're concerned not just with profit maximization, but also accounting issues like book value, and they're constrained by certain, certain capital requirements.
At the end of the day, what we think is the large fraction of these non-economic or quasi-economic investors in the fixed income world really gives active investors in the fixed income space an opportunity to add value.
Uh, another example is the inefficiency of benchmarks in fixed income. So, so you think about, uh, about how different sort of sovereign bond markets are weighted in fixed income indices. They tend to give the most weight to the most indebted countries — Or, in corporate bond industries, the most weight to the most indebted companies.
Uh, so, you know, while we can debate at length the benefit of active management in the equity space, uh, we think that there's a very compelling case to be made for active fixed income.
Justin Blesy: Steve makes some pretty good points. Mary, you know, how is this, uh, debate playing out in the advisor community?
Mary Kralis Hoppe: Yeah. The advisors generally recognize that there's room for both active and passive in portfolios. Uh, they really do need to recognize that the client has to get a good value for the fees paid. So, where there's an efficient market, where it's hard for active managers to outperform consistently — large cap equity being one — that's generally where I see passive at work the most.
And it doesn't take too much work for an advisor to, to see that fixed income is worth, worth paying for, just by looking at their Morning Star reports and seeing the outperformance of fixed income managers. But they never really took the time to dig into why that is. So, when I have conversations about the things you just mentioned, Steve, it's a big aha for advisors, recognizing that fixed income markets are terribly inefficient, and an active manager can work around that and take advantage of it. And the other thing that's interesting is to have the conversations around benchmarks. Uh, and you touched on it a little bit, but you know, when you say, "So, how many stocks are in the S&P 500? How many, uh, stocks are in the S&P 500 passive ETF?" 500 and 500, it's easy to do that. But when you ask, "How many CUSIPs make up the Barclays Aggregate?" Not too many people know the answer to that, and I'm going to guess it's over 4,000. And — Is it?
Mark Thomas: 10,000, actually.
Mary Kralis Hoppe: 10,000, actually. Okay then. Uh, so for an ET—a passive ETF to replicate that is really difficult. So instead, they get a sampling. So, whether they like it or not, advisors are getting active management in passive ETFs. Uh, so what they are trying to do is strike the balance for the clients of where it's worth paying a manager and where it's not so they can get the client the most efficient ride.
Justin Blesy: And then, Mark, maybe at the home office side, how are they balancing this, uh, trade-off?
Mark Thomas: Yeah. I mean, I think, you know, Mary made some great points. It's really about choice, you know. Advisors deliver value to their clients. Quite often, that isn't at the lowest cost, but there are places where cost becomes really important. Uh, and as you mentioned, large cap, large cap value, large cap growth, those areas are areas where, you know, Steve mentioned, pretty efficient markets. It makes a lot of sense to potentially use passive there.
But we really see it as an "and" conversation. So, it's active and passive, together, thoughtfully constructing a portfolio. It's very hard for passive strategies also to focus solely on outcomes. Active managers can do that. Something like income, for example, is much easier generated in active portfolio—
Mary Kralis Hopp: It's true.
Mark Thomas: As opposed to a passive portfolio. But without a doubt, our clients are very price-sensitive. So, the inefficiencies of the, of the fixed income market can work to our favor and can help deliver, uh, those — deliver extra value to those clients, even if the cost isn't necessarily the lowest.
Justin Blesy: Yeah. And you've hit on a theme that we've come back to a few times now, which is outcomes. Uh, and perhaps no bigger theme in terms of how you have—how you can transition clients from the accumulation phase to distributing, uh, a nice income stream in retirement, this retirement income conversation.
Justin Blesy:And, you know, we've actually done a fair number of, uh, client conversations on this over the last year. Uh, perhaps you could provide a little bit more, uh, insight to what those conversations have yielded?
Mark Thomas: Yeah. I mean, it's been, it's been really a fun experience to hear how advisors think about constructing portfolios for clients as they go into and through retirement. I think what was—what we found most interesting is that most portfolios are really… What they do is they increase cash or they reduce risk. Uh, and they do that still while facing and while looking at an accumulation approach.
One of the areas, for example, that we found that we think there's maybe some, some areas lacking, would be in inflation protection. Not necessarily an asset class that's great at delivering income for clients, but if you think about a client who no longer is getting a paycheck, inflation protection of those dollars that they have at the point that they retire becomes a pretty critical function.
But it's really, uh, the interesting thing we've found has been that the reduction in allocation to securities, the increase in cash, and then perhaps going from a 60/40 to a 30/70 portfolio as you, as you adjust down your risk and increase your fixed income allocation.
Justin Blesy: So, just on the asset allocation portion, not a lot actually changing from the accumulation to the decumulation phase.
Justin Blesy: Maybe just modestly tweaking risk. And that's just one piece of the puzzle.
Mark Thomas: Yeah.
Justin Blesy: Uh, in fact, this is a much broader planning conversation, including things like social security and annuities and what's the appropriate withdrawal strategy.
And luckily enough, uh, Steve, you actually recently wrote a paper on this, uh, looking at those multiple challenges, uh, and decisions that need to be made. So, you know, relative to some of the things Mark mentioned, uh, what are some of the insights from your paper that you can share with the group?
Steve Sapra:Sure. Well, you know, as we've already discussed, asset allocation is really complicated. Uh, and my colleague, Ying Gao, and I have recently written a paper on the retirement decision specifically and how to think about the various decisions one needs to make and attempt to provide some structure around that.
So, so asset allocation is complicated, but now, now bring in, "Well, do I take my social security now, or do I defer it to, say, age 70?" Uh, you know, there's always the risk that I live a long time. I mean, it sounds strange to call that a risk, but it means you may run out of money, right?
So how do you think about hedging that? Is there, is there a role for annuities, uh, in that regard? Uh, what's the right amount of stocks and bonds to hold, uh, when you retire, say at age 65?Uh, and so our paper has attempted to put some structure on this. And, and, uh, obviously the paper is available on our website. You can read it. But kind of a high-level sum of the broad conclusions that we found is that, uh, for most people of, of even relatively modest wealth, they're going to want to defer social security and take advantage of that significantly higher payout of deferring from, say, age 65 to 70. All retirees face longevity risk, you know. Uh, and so there's a, there's a role for annuities in, in portfolios across the board that we find.
Uh, the stock bond mix, we find that wealthier individuals want to—should hold more fixed income, uh, and those who are less fortunate actually can, can, uh, afford to take a little bit less fixed income and actually some more equity risk.
And then finally, how much of the portfolio should we draw down? Well, you don't want to look based — You don't want to make this decision based upon sort of historical returns, because returns going forward are likely going to be much lower than they have been since, say, the 1980s.
So what we find is that withdrawal rates on the order of, say, between 2% and 4%, uh, of your principal balance seem reasonable, uh, depending on kind of your, your need to—your desire to preserve, uh, to preserve capital.
Mary Kralis Hoppe: In the past, the 4% rule was kind of the rule of thumb, but now the 4% rule is being dialed back.
Steve Sapra: Yeah. What we find, actually, is that, is that if one were to spend around 4% of their principal balance, uh, they, they would probably run out of money by age 85.
Mary Kralis Hoppe: Wow.
Mark Thomas: One of the interesting things we found as we talked to advisors is that clients, even though they're in retirement, still don't like to draw down the principal. So, having a conversation, a planning conversation about that, becomes important as you think about charitable gifting, as you think about when to take social security, as you think about taxes, because there is this sort of mindset that I don't want to lose what I have. While that may be appropriate at some points in time, if it's with a thoughtful financial plan in place.
Mary Kralis Hoppe: And that's a — You bring a pain point advisors have, is not just about loss and longevity. It's all of it, like where do I put the assets? It's asset location that is a skill set advisors have had to really get up to speed very quickly on.
Justin Blesy: Yeah, so not, not an easy task, but hopefully a few insights, both from behaviorally, what advisors are doing, and maybe how to manage it, manage some of those risks, as well as analytically.
Uh, you know, turning to our, our last topic, which is the road ahead, uh, Mark, I'd actually like to start with you. Uh, you know, we see portfolio construction trends evolving in terms of the way advisors and home offices approach it.
Mark Thomas: Yeah.
Justin Blesy: Uh, could you maybe give us a little bit of sense of the things you've been seeing over the last several years and where we go from here?
Mark Thomas: Yeah. I mean, what we've seen is really sort of a development of model solutions, uh, for advisors, sort of traditional advisors who focus on other areas of their business or practice, thinking of CPAs who run money or advisors who focus on insurance sales. They've been using the 60/40, the 80/20 model portfolios.
What we see a lot from home offices and from advisors today are these outcome—asks for outcome-oriented portfolios. "I need a portfolio that's focused on income. I need a portfolio that can help deliver me tax efficiency, that's thoughtfully constructed around municipal securities," perhaps, in addition to portfolios that focus on, let's say, inflation protection or focus on a specific asset class.
That's becoming — As advisors now that build their own portfolios and likely will continue to do that, they may have equity models that they build, so they might want a complementary fixed income model, or they might want a retirement income model.
So, we see an increasing, uh, demand for what I would say are complementary, outcome-oriented strategies to help put pieces together for the advisors based on either what they're willing to outsource or what they have a core competency delivering themselves.
Justin Blesy: Mary, are you seeing similar trends?
Mary Kralis Hoppe: Yes, yeah. You know, many advisors — you mentioned like the CPA who does CPA work, uh, as their value proposition, so they feel a little bit more comfortable outsourcing the investments. But by and large, most advisors that we work with here at PIMCO, they built their client relationships upon the investments.
And so, here they are now being charged with doing so many more things for the client, there's not enough time in the day to get it all done. So, they're trying to figure out ways to be more efficient with the investment process. And, uh, they still want to retain some control, and that's a function of, A, something that they enjoy, and B also, the things clients bring to the table.
A lot of the clients come to the equation with a low-cost base of stock position that was inherited, or a restricted stock position, and the advisor has to figure it all out. Not everything fits nice and neat into a nice model. That said, they do need to find efficiencies. And this is where I see a couple of approaches.
Uh, for smaller clients, maybe outsourcing completely into a home office model that the, uh, home office is providing. For bigger clients, figuring out what parts of the household can be more efficient. The, the growing trend I see, however, is advisors saying, "I just don't have time to put it all together, so I'm going to rely upon my home office for some guidance, I'm going to rely on third-party managers for some asset allocation input, I'm going to rely upon other asset managers, and I'm going to create my own portfolios with this sort of advisory board of resources that I've created."
Uh, and so, what that means then is they still have less time in the day to monitor all of the players, right. So, they're saying, "Okay, now I need to reduce the number of asset managers I align with. Uh, and if I'm going to align with less than, I need to make sure that they have a broad product offering that I can tap into."
And it would be really nice if these managers also brought more to the table, whether it be thought leadership, analytical tools, whatever it might be, and I see that the asset management industry is really up to their game in this regard, trying to be far more valuable to the clients, their advisors. While advisors are trying to be more value to their clients with doing more things, asset management firms are doing the same with their advisor clients.
Justin Blesy: And what about, you know, access and delivery of models? As Mary mentioned, you know, home offices have always had their models for a long time. Mark, you mentioned — actually both of you mentioned third-party models. Where do those come into the equation today, and where do we see them coming into the equation in the future?
Mark Thomas: Yeah. I mean, there's definitely a big increase in demand from the home offices to add what we call sort of third-party strategists or third-party models to the platform. I think that helps legitimize the business. It helps diversify the options that advisors have to choose from.
When advisors are out there working with clients, they want to present the best of breed, whether it was years ago with stock or a mutual fund, or now a strategist to their clients. How do I deliver the best fixed income model with the best equity model? How do I think about price? How do I think about active/passive?
So all of these different types of providers are being brought to the table, tactical risk-on/risk-off managers, strategic managers, uh, all trying to sort of think about what do they do, what do they bring uniquely to the table.
When you think about PIMCO, we do that by leveraging our fixed income heritage, uh, our look-through and ability to manage our own portfolios, our own strategies, and be able to put and construct models, delivering those outcomes using all the risk factors and tools, uh, that Steve puts, uh, that Steve mentioned earlier. So, we try to, uh, you know, deliver a best of breed, yet differentiated strategy ourselves to help complement what's out there in the marketplace today.
Justin Blesy: So it's, in some ways, essentially an evolution because managers do that today with individual funds.
Mark Thomas: Yeah.
Justin Blesy: The next generation is going to be with models.
Mark Thomas: I think that's exactly right. It allows to be more holistic. It allows the manager to add another layer of value to the equation, and hopefully, uh, as Mary mentioned, give the advisor a little bit more time back in their day so that, once they work with a small group of managers they trust, who their values are aligned with, that they can deliver a great solution to that client, and then go focus on growing their business, knowing their client better, doing the financial plan, working with their accountants, spending time with their lawyer—
Mary Kralis Hoppe: Getting that outcome.
Mark Thomas: Yeah, making sure the client knows not to panic when the market goes down, uh, 200 points in a day, all of those really critical things to help the client stay invested.
Mary Kralis Hoppe: All the while doing so in a very cost-effective way.
Mark Thomas: Yes, of course. [laughter]
Justin Blesy: So, if we, if we've probably taken away one thing, it's no easy task in terms of portfolio construction and everything that is related to that. Uh, so maybe I'll ask each of you — and starting with you, Steve, uh, if you could leave our audience with just one thing from your perspective that they take away from today, what would it be?
Steve Sapra: So, Justin, I think all the things that we've talked about today are really important. But I guess if I had to distill it down into one thing, it would be sort of what I mentioned at the beginning of the conversation, which is just making sure that return expectations going forward are grounded in the reality of, of today's markets. Investors have a tendency to look to the past for return guidance, and that's understandable. Uh, but looking at the past is only, I would say, quasi-informational, and at worst, outright dangerous.
Uh, you know, for example, it's just, it's highly unlikely that we're going to see returns over the next 10 year, 10 or 20 years that are the returns that we've seen to US equity since the 1980s. If you think about where markets were in the 1980s, PE multiples were very low compared to today, and, and nominal and real bond rates were very high. And as bond rates came down over the subsequent 30 years, that provided an amazing tailwind for equity investors.
Uh, that experience is unlikely to repeat itself today because, for the simple fact that PE multiples are much higher today and interest rates are much lower today. Uh, and so it's just unlikely that we're going to experience going forward what we've seen for the past, uh, 20 or 30 years.
So portfolios, whether they're fixed income only or asset allocation portfolios combining, uh, say fixed income and equity, uh, if they use realistic, forward-looking returns that are grounded in the reality of today's market, they'll, they'll result in allocations to asset classes that properly trade off reasonable forward-looking returns and their risks.
Justin Blesy:Mark, same question for you.
Mark Thomas: I'll keep it short. I think it's probably a pretty consistent message, but you know, as we talked about, things get more complex, uh, life gets more complicated, uh, and the objectives and, and goals of our clients stay the same. But to meet them, we have to manage expectations. We have to deliver, uh, some transparency and communicate to clients what they can expect on a forward-looking basis. We have to be consistent in doing that.
And then we have to, uh, you know, we have to focus on the outcome, perhaps more than the alpha, so that the combination of the portfolios, the objective towards the plan is really, is really where the client needs to, uh, focus, rather than specific strategies in alpha. And I think that's more important now than ever.
Justin Blesy:And Mary?
Mary Kralis Hoppe: From the advisor’s shoes, the job requires a broader skillset. It requires more time-consuming engagement with the client, all at a time when you've got an uncertain investment outlook and you've got rising rates and you've got fee compression. And so, advisors need to find efficiencies where they can, to provide the right outcome, all at the same time growing their business to be sustainable. And that's going to be critical going forward.
Justin Blesy: Thanks Mary, and thank you Mark and thank you Steve for providing your insights on the portfolio construction conversation. We appreciate everyone joining us today for the Master Class. Uh, hopefully you've taken a few insights to take back to your practice.