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The Fundamentals of RAE: Adding Value to Value

Value investing may offer compelling benefits in a maturing cycle – and we believe the RAE strategy offers a better approach to value.

The period since the 2015 launch of the Research Affiliates Equity (RAE) mutual funds has been challenging for value investors, putting the funds’ contrarian approach to the test – though ultimately highlighting their resiliency. At this three-year milestone, Research Affiliates Founder and Chairman Rob Arnott and CIO Chris Brightman, portfolio managers of the RAE funds, look at why RAE may offer an attractive complement to investors with large exposures to growth sectors dominating traditional indexes today, providing current views on positioning and factors contributing to the RAE strategies’ resiliency relative to value benchmarks and peers since their 2015 launch.

The RAE mutual funds are a suite of systematic active value strategies managed by PIMCO’s strategic partner, Research Affiliates.

Q: The RAE mutual funds launched at PIMCO three years ago, based on strategies introduced by Research Affiliates back in 2004. Can you discuss the RAE strategy, the market environment since the funds were launched and the outlook for this approach?

Arnott: Economist Harry Markowitz has observed that there are only two “free lunches” in investing: diversification and mean reversion. RAE is a systematic active value strategy that aims to provide long-term capital appreciation by harnessing these return drivers. RAE’s strategy, informed by equity insights gleaned from 14 years of continuous research by Research Affiliates’ portfolio management team, drives the fund as it aims to “buy low and sell high” as stock prices fluctuate. This gives the strategy a distinct value orientation that seeks to profit from mean reversion in asset prices.

The years since the funds launched have been challenging for value investors, to say the least. While the Russell 1000 Value Index is up a robust 34%, the Russell 1000 Growth Index has risen nearly double that, up 66% (see Figure 1). The growth/value gaps for the MSCI ACWI and EAFE indexes are similarly vast. It’s fair to say that value has been left in the dust!

During the first half of 2018, 95% of the U.S. stock market gain (as proxied by the S&P 500) can be explained by the performance of just six stocks: Facebook, Amazon, Netflix, Google (Alphabet), Microsoft and Apple, the much celebrated (and maligned) “FANMAGs.” A lot of ink has been spilled over the various potential asset bubbles around the world (including in our own piece this year, “Yes. It’s a Bubble. So What?”1).

To summarize the perspective from our research: Reasonable people can disagree about whether growth equity markets (and the tech high-fliers that have driven them) are in a bubble or not. However, we agree with those who say that large swaths of the market today are decidedly not in a bubble.

Large performance gap between growth and value since the RAE funds’ inception

Our research indicates that value stocks are trading at unusually large discounts, especially compared with growth stocks, all over the world. We’ve also written before on why we believe starting valuations can be a strong predictor of long-term future returns for factors, styles and strategies.2 The growth-value spread in emerging markets is very near an all-time high. Given starting valuations, we believe that if investors significantly reduce equity allocations away from traditional market-cap exposures (especially in the U.S.) and into value-based strategies (especially in the “half-priced”3 European and emerging markets) they are likely to enjoy higher long-term return potential. RAE’s value orientation goes a step further, adding a potential rebalancing alpha on top of any benefits derived from investing in value in these various markets.

Q: How have the RAE strategies performed versus value peers and benchmarks, and what is RAE’s key point of differentiation versus a typical value strategy?

Brightman: Given the growth-versus-value backdrop Rob describes, we’ve been pleased with the RAE mutual funds’ resilience over the past three years versus value indexes and value peers.

The key differentiator of the RAE strategy, in our view, is that as markets become more distorted – that is, as the disconnect between valuations and fundamentals becomes more extreme – an RAE portfolio is designed to consistently (and unemotionally) trade, buying those stocks that are most unloved and selling or avoiding those that are today’s darlings. In this way, the value orientation of an RAE portfolio will not merely persist or remain static, as is typical for some traditional value managers and indexes, but may in fact deepen just as the bargains are among their greatest. In our view, this dynamic value tilt is what allows RAE to benefit over time and is the primary reason that all four of the PIMCO GIS RAE funds are well ahead of the value indexes (see Figure 2). In the short term we anticipate RAE will continue to outpace value benchmarks, and in the long term we expect RAE to outperform the broad markets as a whole.

Q: How has this dynamic value tilt affected the RAE funds’ current positioning?

Brightman: We think two aspects of current RAE portfolio positioning are noteworthy: valuations and sector weights. 

An RAE portfolio should always trade at a discount to the broad market. However, when valuations in pockets of the market move higher and higher, and other market segments are left behind, the portfolio’s discount to the market should go even deeper – and that is precisely what we’ve seen over the past three years. Consider two of our longest-tenured strategies: RAE U.S. and RAE Emerging Markets.

PIMCO RAE strategies have delivered consistent long-term excess returns

For the most recent quarter-end performance data for the PIMCO RAE funds in the table above, please click on the links below:

RAE U.S. Representative Account discount to value index has steepened

  • Since 2004, the RAE U.S. strategy has had a median discount to the S&P 500 of 21%. Since 2016 that discount has steadily deepened, to 35% today – a level not seen for nearly a decade (see Figure 3). Even more interestingly, RAE has exhibited only a minimal discount to value indexes over time, but today the RAE U.S. strategy has crept down to a 12% discount to the Russell 1000 Value Index.
  • Since 2006, RAE Emerging Markets has had a median discount to the MSCI Emerging Markets Index of 24%. Since 2016 that discount has steadily deepened, to 43% currently – near an alltime low (see Figure 4). The strategy’s discount to the value market (the MSCI Emerging Markets Value Index) is now 24%, much lower than its historical median of 8%.

If the current valuation of a given asset is a key determinant of its future returns (and as Rob stated, we believe it is!), then we believe RAE is poised to add value across the market segments in which the funds invest.

RAE Emerging Markets Representative Account discount to value index is at an all-time low

Another (related) aspect of this dynamic value orientation is that RAE portfolios will have meaningfully different sector weights than the broad market-cap-weighted indexes over time. In the U.S. and emerging markets, this currently translates to a significant overweight to financials and an underweight to technology; in developed markets outside the U.S., this is expressed with a similar overweight to financials but an underweight to consumer staples (as of 30 June 2018). At a given moment, individual stock, sector and country weights are a function of where the RAE strategy is finding the greatest value. Investors with large exposures to technology and other sectors that dominate traditional indexes today may find RAE to be a reliable complement.

Q: Given the tendency of markets to move in cycles and revert to the mean, what might be the catalyst for value today? When could value investing come back into favor and close the discount gap to growth?

Arnott: History can be instructive, providing valuable lessons and teachable moments for investors. But markets do not teach us what makes for successful timing of an inflection point – that confluence of economic, sentiment, technical and market forces that sets off a rotation in market leadership from one group or style to another.

It bears emphasis that catalysts are often a surprise. It’s a fun parlor game – sometimes profitable and at other times painful – to try to anticipate the next catalyst. But sometimes markets turn without any apparent catalyst at all! Can anyone say with exact certainty what caused the market shift from growth to value in March of 2000, when the technology bubble spectacularly began to implode? I have yet to meet a person who can credibly explain why the inflection happened when it happened, and how predictive that is for future market shifts. “Gravity” may be the simplest and best explanation.

That said, there are some intuitive signals that tell us we may be closer rather than farther away from a shift in value’s favor. Beyond the widening valuation discount and performance disparity of growth and value, there are fundamental reasons why value could be favored going forward. If we enter an environment characterized by higher interest rates or increased inflation (or both), then sectors positively correlated to those increases could benefit. These include financials and energy, which are large constituents of value (and cheaper corners of the market today). Conversely, large segments of the growth market include technology, health care and consumer staples, sectors that demonstrate a negative sensitivity to rising rates and inflation (see Figure 5). As the economic and market cycle matures, we believe in the return of the value premium.

Value-oriented sectors look attractive when rates

At PIMCO, we bring a different perspective to equity investing. We believe our unique, innovative equity solutions like the ones that come from our partnership with Research Affiliates offer a better way forward and a different source of excess return potential than traditional actively managed equity strategies. Research Affiliates is the sub-advisor of the PIMCO RAE Funds and has been PIMCO’s strategic partner for over 15 years. From the complementary skill sets of two industry-leading firms, to our shared commitment to pursue investment excellence, together we work relentlessly to provide our clients with best-in-class investment strategies that aim to deliver across all market environments.

For more ways to elevate your equity potential, visit our equities product finder.

1 See “Yes. It’s a Bubble. So What?” by Arnott, Shepherd and Cornell (April 2018).
2 See “How Can ‘Smart Beta’ Go Horribly Wrong?” by Arnott et al. (February 2016); “To Win with ‘Smart Beta’ Ask If the Price Is Right” by Arnott, Beck, and Kalesnik (June 2016); and “Timing ‘Smart Beta’ Strategies? Of Course! Buy Low, Sell High!” by Arnott, Beck, and Kalesnik (September 2016).
3 Stocks in the U.S. have a cyclically adjusted price to earnings (CAPE) ratio of 32x, whereas stocks in Europe are trading at a CAPE of 16x.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Chris Brightman

Chief Executive Officer and Chief Investment Officer, Research Affiliates

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