Robust returns for value stocks in 2016 highlighted why patient investors may benefit from the RAE Fundamental strategies’ contrarian approach. But with a return to growth testing value investors this year, it’s worth remembering how the RAE strategies may benefit from these market reversals.

In this Q&A, Research Affiliates’ Chairman Robert Arnott and CIO Christopher Brightman, portfolio managers of the PIMCO RAE Fundamental strategies, provide perspective on how periods of underperformance for value are part and parcel of these strategies’ contrarian approach – and why a painful 2017 for value thus far may position investors for future returns.

Q: What are your views on the underperformance of value this year?

Arnott: Clearly, 2017 has been a painful year for value investors. In any given year, the odds that value will outperform growth are basically a coin toss,1 but even so, the magnitude of value’s shortfall this year is unusual: The Russell 1000 Value index has lagged Russell 1000 Growth by more than 12 percentage points (at 7.9% versus 20.7%). It isn’t fun to stick with a disciplined, value-based approach when prices for the “FANMAG” stocks (Facebook, Amazon, Netflix, Microsoft, Apple and Google), along with niche fliers like Tesla, seem to go up every day.2

But there’s a real and meaningful silver lining: Value is now historically cheap relative to growth, particularly outside the U.S. We would not necessarily expect such a short period of poor returns from value to presage an immediate recovery (though that’s certainly possible), and we do not have a crystal ball to tell us how the rest of 2017 will play out. But history has shown that investors have often been rewarded for sticking with value after experiencing periods of underperformance. Following short periods (i.e., six months) when value lagged growth by more than 9 percentage points, the average subsequent recovery in value, relative to growth, was 18% over the next three years. And that’s for the index (Russell 1000 Value), not for the RAE strategy. Because RAE trades into a deeper value tilt as value underperforms, the rebounds have the potential to be even stronger for RAE.

Meanwhile, growth companies that were expensive entering 2017 have only appreciated further. Last year we wrote a series of papers examining the powerful relationship between valuations and subsequent returns.3 While value stocks by definition trade at a discount to growth stocks, the magnitude of that discount changes over time, and it has become steeper this year according to the methodology outlined in these papers.4 Prices of value stocks ended 2016 at 28% the price of growth stocks, slightly above the long-term median of 27.1%, but have since fallen below the median, to 24.8%.

Figure 1 shows nearly a half-century of performance for value stocks relative to growth stocks (in blue), along with the valuation of value relative to growth (in gold), highlighting the strong link between valuation and return. Importantly, value has outperformed growth net of valuation changes – hence the “wedge” between the chart’s blue and gold lines. A dollar invested in 1968 in a hypothetical portfolio that is long the value stocks and short the growth stocks would have grown to more than $2.50 at the end of June (does not include the impact of fees and would be lower, if applied), despite compression in valuations of value stocks relative to growth.

We view this spread between returns and valuation as a kind of “structural alpha”: While returns and valuation are closely related, value investing may generate an additional premium over and above valuation changes.

Figure 1 shows performance for value stocks relative to growth stocks (in blue), along with the valuation of value relative to growth (in gold), from 1968 to mid-2017. Starting in the late 1960s, the two metrics diverge, and a wedge between them shows how value has outperformed growth net of valuation changes. A dollar invested in 1968 in a hypothetical portfolio that is long the value stocks and short the growth stocks would have grown to more than $2.50 at the end of June 2017. The graph shows the two measures generally moving in the same direction over time. Relative valuation ends where it started, at about 0.25. Notes and definitions are below the chart.

If history is any guide, while 2017 has been challenging to date, the period has created an opportunity for disciplined value investors with long-term horizons. RAE has taken on a deeper value tilt now – after value has become cheaper – than it had a year or two ago. That’s part of the potential power of the strategy.

Our long-term investors know that what makes the RAE strategy special is, in part, that it seeks to trade into the drawdowns, patiently and gradually, in an effort to earn back the shortfall in value with potentially room to spare. And while history is not a precursor to future results, it has shown that these drawdowns can be essentially a coiling of the spring: The snapbacks have often been fast and sizable. These excess return opportunities have been possible because of the drawdowns, which have set the stage for bigger recoveries, and not because of steady-state markets in which we add value slowly and steadily.

Of course, one core attribute of RAE is its value bias – sometimes modest, sometimes deep. When value struggles, so do returns for RAE. We then trade into a deeper value tilt, so that when value recovers, we will be positioned to potentially earn back the shortfall, and then some. Then we trim it again. As they say, “rinse and repeat.”

Q: How has the underperformance of value affected the positioning of the RAE portfolios?

Brightman: A brief review of our RAE strategy helps further explain how periods of underperformance position RAE for future returns.

We employ a systematic active investment process built upon a foundation of contrarian rebalancing. To seek to capitalize on long-horizon mean reversion, we rebalance the weights of the stocks in these portfolios back to the relative economic size of the issuing companies. We augment this simple rebalancing by adjusting the anchor weights to which we rebalance to reflect the quality of the business. We then measure momentum to improve the timing of our trades and seek to avoid catching “falling knives” or selling winners too quickly.

Since launching our contrarian RAE portfolios in 2004, we’ve experienced a number of shortfalls for value similar to what we’re seeing this year. During short-term periods when growth was handily outperforming value, RAE failed to keep pace with the market. But the other side of this coin is a wider valuation discount for RAE – setting the strategy up for subsequent periods of strong outperformance (see Figure 2).

Figure 2 is a bar chart comparing historical alpha of PIMCO RAE Fundamental U.S. Fund versus that of the S&P 500 for eight value-versus-growth return scenarios. For each scenario, the chart shows concurrent six-month alpha and subsequent three-year alpha. The bar chart shows that when value versus growth returns were negative, the fund outperformed the S&P for the subsequent three-year period. Its highest value was 4.5% more than the S&P when value versus growth returns were negative 9% or more. Conversely, the fund trailed the S&P for periods when value-versus-growth returns were positive, but the amount by which it trailed was not as great as its gains when value versus growth was negative. A table underneath the chart includes more details.

Similar to what Rob noted above for value stocks more generally, the RAE strategies have shown strong relationships between relative valuations and subsequent returns (see Figure 3) – no surprise, given our disciplined contrarian approach. And this relationship holds globally, across the U.S. and emerging markets portfolios.

Figure 2 features two line graphs, one showing cumulative excess return of the RAE Fundamental U.S. Fund, the other doing the same for the RAE Emerging Markets Fund. The first graph shows the RAE U.S. Fund’s cumulative excess return versus the S&P 500 from 2004 (fund inception) through 30 September 2017. Cumulative excess return was at around 2% in September 2017. Yet the fund’s relative valuation to the S&P 500 at that time was just 68.7%, compared with a median of 79.1%. The graph for the RAE Emerging Markets Fund, covering 2006 (fund inception) to 30 September 2017, shows excess return versus the MSCI EM Index at about 25% in September 2017, and relative valuation of the fund was at 59.8%, compared with a median of 75.7%.

Our inherently contrarian RAE methodology calls for buying more value when value is deemed to be “cheap,” thus enabling us to potentially generate excess returns even during long periods of underperformance. We have generated excess returns since inception after fees in the U.S. and emerging markets RAE portfolios despite underperformance from value in each region (see Figure 4).

We are excited to see the excess returns RAE may generate when value returns to favor and this headwind becomes a tailwind.

Figure 4 features a bar chart and table showing how RAE strategies historically delivered excess returns since inception through 30 September 2017. Excess return versus the core indices for the U.S. Fund were three basis points, and it outperformed the value index by 85 basis points. The greatest excess return versus the core index was shown by the RAE Fundamental International Fund, which had alpha of 177 basis points. It outperformed the value index by 220 basis points. A table beneath the chart includes fund names, inception dates and the funds’ relevant benchmarks.


1 The Russell 1000 Value Index has beaten Russell 1000 Growth in 48.9% of all rolling six-month periods since 1979, as of 30 September 2017.
2 For more of our views on the importance of discipline when a subset of stocks seems destined to appreciate endlessly, see “Are You Underweight FANMAG? Chillax!” published June 2017 by John West and Amie Ko.
3 See “To Win with ‘Smart Beta’ Ask If the Price Is Right” (published in June 2016 by Rob Arnott, Noah Beck and Vitali Kalesnik), which examines the relationship between valuations and returns on long-short factor portfolios and long-only equity strategies globally.
4 We calculate valuation via a blend of four metrics: Price/book, price/five-year sales, price/five-year earnings, price/five-year dividends.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Chris Brightman

Chief Executive Officer and Chief Investment Officer, Research Affiliates


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