Strategy Spotlight

A Systematic Equity Approach Rooted in Fundamentals

Research Affiliates’ Founder Rob Arnott and Chief Investment Officer Chris Brightman discuss the 10+ year process that powers RAE Fundamental’s excess return potential, why the strategies are well positioned to add value in today’s markets and their long-standing, client-focused partnership with PIMCO.

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John R. Cavalieri, Product Manager, Asset Allocation: Hello, my name’s John Cavalieri at PIMCO. Today I'm joined by Rob Arnott, founder, chairman and CEO of Research Affiliates, and to Rob’s right is Chris Brightman, chief investment officer at Research Affiliates. Gentlemen, thank you for joining us here today.

Rob Arnott, Chairman and CEO, Research Affiliates: Thank you.

Chris Brightman, Chief Investment Officer, Research Affiliates: You’re welcome.

John: The goal of today is to provide an overview of the PIMCO RAE Fundamental Equity Strategies. So to kick things off, Chris, let me turn to you. Can you provide an overview of the strategies as well as some of the methodology and philosophy behind them?

Chris: The RAE Strategy is a systematic, active approach to adding excess return in equity markets. We start by measuring the fundamental size of all of the companies in the publicly traded equity market.

Chart: The chart is a j-curve that outlines the philosophy of RAE fundamental. Starting with price, the line slopes upward from a fair value level, peaks and then slopes down, passing the fair value level, troughs and then returns upward toward price again. The move is from selection, to incorporation to rebalancing.

We rebalance portfolios back towards those measures of fundamental company size, trading against the excess volatility in equity markets. It's essentially using rebalancing as a value-enhancing tool.  And in that sense, it is a value-oriented strategy. But the RAE strategies add a number of important insights beyond simple, fundamental weighting.

First we start with understanding the quality of the company. We use a number of characteristics that are shown to forecast returns by focusing on the fundamental quality of the underlying business. So by systematically measuring quality of all of the companies we can greatly improve our selection of which companies to include in the portfolio and those that should be overweight.

The next step in the process is using momentum. Momentum isn't about understanding the company and the business; it's understanding the patterns of price movements in the markets. So by measuring the momentum in markets, we change the pattern of our trading activity. If a stock’s attractive and we want to add it to the portfolio, we'll add it more slowly if it has negative momentum. If we're getting ready to sell a position because it's become expensive, we will sell it more slowly or wait if it has very positive momentum, let that momentum run its course.

We also have a couple of steps that are at the portfolio level rather than the security level. We use what we call diversification of style. Since it already is a value strategy, we try to make sure that we are only in truly cheap stocks. Not just stocks that co-move with other value stocks. If we find a stock that has value factor risk — co-moves with other value stocks — but isn't cheaply priced, we're going to kick that out of the portfolio.

On the other hand if we can find cheap growth stocks — stocks that don’t co-move with other value stocks, stocks that seem to be priced like other growth stocks or behave like other growth stocks, but they're temporarily cheaply priced, we especially favor those in the strategy.

Lastly, another portfolio construction technique that we employ is called diversification by size or I think of it is as making better use of your active share.

If you simply look at the portfolio construction of a typical fundamental index or simple smart beta strategy, all of the bets tend to be concentrated in the very largest companies. They have very large weights in both the smart beta strategy and in the market cap weighted portfolio. Hence great, big active bets.

The determinants of the relative return of the portfolio, the return of the portfolio versus the index are dominated by those few dozen huge stocks. That's not a very smart portfolio construction technique. We systematically reduce the magnitude of the active bets of all the biggest companies, and redistribute that active share very broadly across the many, many hundreds of smaller companies that also have significant opportunities.

Not only does that greatly increase the diversification of our active bets, but it also makes bigger bets in the smaller companies that tend to be less efficiently priced. You're just fishing in a richer pond when you're looking at those small to medium-sized companies.

John: And if you were to summarize the benefits that result from that methodology, what would be your elevator explanation, so to speak?

Chris: Well, there's the benefit of being value-oriented and contrarian, systematically trading against the excess volatility in the market — the market’s constantly shifting opinions as to which companies ought to be receiving premium or discount multiples. So that contra-trading is a considerable benefit.

Using a modeling process, using a systematic process ensures the discipline of actually executing it. Contrarian trading is easy to understand. Everybody would like to buy low and sell high, but it's never easy, is it? So I think that systematic active allows us to create a more consistent excess return, but do so with a transparency and keeping fees reasonable.

John: Thanks for that overview, Chris. Rob, can you talk about the history of collaboration between PIMCO and Research Affiliates in deploying these strategies for investors?

Rob: We have had a wonderful affiliation going back now almost 15 years, and that affiliation spans global asset allocation, equity strategies, low volatility equity strategies, portable alpha, a whole array of strategies, and the wonderful thing about it is that PIMCO and Research Affiliates share an obsession with winning on behalf of the end customer.

The goal is to create disruptive ideas that change the way people think about investing and improve their outcomes. And so this has just been a natural next evolution of what's been a terrific relationship.

John: Great. Well, on behalf of Rob Arnott and Chris Brightman. Thank you.

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