Shannon Zimmerman: In the fund research group here at Morningstar, we're fundamentally focused, but a lot of us have interest in quantitative analysis, as well. So, I am very excited to talk to you in your capacity as the person who oversees PIMCO's quantitative portfolios.
So, talk a little bit about the inputs that you use there and then sort of drill down if you would on price momentum. My question there is why such a simple strategy? If you look at the Carhart method which is really just 12 months of what's done well and then you back out I think the last of the 12 months' returns and then re-sort, and there are your contenders and you just buy those, the track record over a very lengthy time series is remarkably impressive. Why hasn't such a simple strategy been arbitraged away?
Vineer Bhansali: I think the reason it hasn't been arbitraged away, and we'll go backwards here on your question, is because it has to do with behavior of participants. And in equities, information about stocks that's available to most market participants is not particularly long, and as a matter of fact, when they react to it, they are looking at recent price behavior and saying, "What's been going up? Let's buy what's been going up." And this can be traced back to our own behavioral biases. We look to anchor our expectations to what has recently happened, or representation of what has recently happened drives our behavior.
So, it works. It works, and the reason it hasn't been arbitraged away is because people's behavior cannot really be arbitraged away unlike real cheap opportunities in equities or in bond land where you can buy something and sell something else. You really can't short out something else that'll give you a risk-free profit against momentum. So, there are theoretical reasons why momentum doesn't get arbitraged away. We have found, like others, have that momentum doesn't just exist in equities where you can do quintiles of longs and shorts based on momentum risk factors, but you can also do it across asset classes, you can do it across commodities and you can do it across interest rates, you can do it across...
Zimmerman: Regional boundaries, as well.
Bhansali: Exactly, and momentum is a very pervasive common factor. And one of the interesting ways we’ve been using it for multiple years is as a diversifier. What we found is that when the bounds of mean reversion break, when valuation becomes less important and this usually happens when people start to romance a possible bimodal outcome in our speak or a potential fat-tailed outcome, the bounds of mean reversion break and markets start to trend. And that’s when the momentum risk factor really shines, for example, in 2008 right during the financial crisis. So we think of momentum not as an investment asset, but as a risk factor, and that’s consistent with our overall risk factor approach to asset allocation. And we do use it as a cyclical risk factor to allocate both for risk management reasons, as well as for portfolio enhancement.
Zimmerman: Have you looked at the low-volatility premium? I moderated the panel yesterday that was about high dividend and low volatility and the correlation between them and whether or not investors might need both exposures in their portfolios. The low-volatility premium is impressive, as well. There is a paper that came out last year, and it looked at a 41-year time series. I think it found outperformance comparable to what the price momentum strategy has done over a similar length of time. Why does that persist, and then do you use that at PIMCO, as well?
Bhansali: So, we do use it in a certain form. For example, there is documented evidence that in certain bond asset classes, for example, in the cusp of investment-grade versus non-investment-grade there are opportunities, and that can be traced back to the low-volatility premium. Now, there are two things that I was say here. The first one is that the low-volatility premium has been observed as an anomaly looking backward. But there is no consensus at least within investors and academics that this would hold forward going in the future.
There are also theoretical reasons that people have talked about--that’s the second point--why the low-volatility premium might actually exist and some academic work [has shown] it has to do with potential aversion of leverage, and that's the theoretical reason. And again, there is a lot of discussion going on that topic on why that might exist. Now, people have used it as we have in many of our strategies of taking low-volatility asset classes and exposing our portfolios to a higher amount of them. If you're thinking of something like volatility targeting or thinking of something that's usually today called risk parity, you can take low-volatility assets and have a little bit more of them. And if he can now generate the extra risk premium then you can create a portfolio that's more robust.
So fundamentally, it makes sense to me, that you should be using this toolkit in portfolio construction. You have to be careful though that the low-volatility assets that you are picking are indeed going to be low-volatility going forward and don't have a hidden fat left tail inside of them. And if you can do that, then clearly there is something to be had for nothing.
Zimmerman: To one of the earlier points that you made, it's always good to have a healthy dose of skepticism when you're looking at any back-tested results, and there seems to be some doubt about whether or not low volatility might persist going forward. Is there a doubt about price momentum?
Bhansali: Yes, and I think there are periods. There has been again good academic research which shows that even price-momentum-based strategies can have very significant drawdowns.
Zimmerman: The inflection points especially.
Bhansali: Especially inflection points, and we saw that in 2009, where price momentum didn't do very well.
I think the half-life or the time at which price momentum might get arbitraged away is probably a little bit longer, because people's behaviors don't change immediately. And so, I think there is a little bit more time for this theme to work out, but you have to be cautious. You know there is a lot of momentum and trend-following activities in the marketplace today, and they're all doing lot of the same thing, and there is risk but they all try to get out at the same point in time if something bad happened because you have to control explicitly for that left-tail.