These funds are more like hedge funds than regular mutual funds. But returns have been good and fees are not outrageous. By Steven Goldberg, Contributing Columnist August 15, 2012 There's a cardinal rule in investing: Never buy anything you don't understand. But I think it's okay to break this rule occasionally. Consider the Pimco All Asset funds.SEE ALSO: Our Special Report on How to Be a Better Investor I've spent countless hours studying them, including a couple of hours interviewing manager Rob Arnott. I understand the general ideas, but key details still elude me. Arnott's funds are complex; they're more akin to hedge funds than mutual funds (although their costs are much closer to those of mutual funds than the exorbitant charges of hedge funds). Sponsored Content Why even consider investing? Start with superb returns. Over the past ten years, Pimco All Asset Institutional (symbol PAAIX) returned an annualized 8.5%, or an average of 2.1 percentage points per year more than Standard & Poor's 500-stock index and 3.1 points per year more than the Barclays Aggregate U.S. Bond index. Over the past five years, Pimco All Asset All Authority Institutional (PAUIX), which is a juiced-up version of All Asset, returned an annualized 8.5% -- 6.6 points per year better than the S&P 500 and 1.8 points per year ahead of the Barclays Bond index. (Unless otherwise noted, returns are through August 14. Note that you normally need big bucks -- at least $100,000 -- to invest in Pimco's institutional share classes. If you can't meet the stiff minimums, you can buy the All Asset funds' class D shares, which charge 0.4 percentage point more per year than the institutional shares and, therefore, will almost certainly lag the cheaper funds by that much.) Advertisement Volatility? All Asset and All Authority have been about half as volatile as the S&P 500 but about three times as volatile as the Barclays Bond index. In the 2007-09 bear market, when the S&P index tumbled 55.3%, Pimco All Asset lost 24.4%, and All Authority surrendered 16.1%; the Barclays index gained 7.2%. All Authority is only a smidgen more volatile than All Asset. The other plus: These funds display low correlations with developed-market stocks and investment-grade bonds. That makes them good diversifiers. The idea behind "alternative investments" (almost all of which are lousy investments, in my opinion) is to give your portfolio more diversification, lower its volatility and boost long-term returns. So far, the All Asset funds have done all those things. How does Arnott do it? Although Arnott employs 25 analysts at his Newport Beach, Cal., firm, he says his computer models do most of the heavy lifting. Arnott's firm, Research Affiliates, is independent from Pimco, which is also based in Newport Beach, but his funds can invest only in 40 Pimco funds -- which focus on assets ranging from stocks to commodities to bonds to currencies. Advertisement Arnott says he begins the asset-allocation process by looking at an investment class's current yield and his firm's estimate of the capital appreciation potential (or lack of it) for each of the 40 Pimco funds. For instance, the S&P 500 currently yields 2.0% and historically has seen those dividends grow about 1.5 percentage points per year more than the inflation rate, Arnott says. Assuming annual inflation of 2.25%, you get a projected after-inflation return for U.S. stocks of a bit less than 6% a year. Currently, those measures -- and a welter of others -- lead Arnott to huge weightings in emerging-markets bonds (30% of All Asset's assets) and domestic high-yield, or junk, bonds (also 30%). He has another 12% in emerging-markets stocks. Arnott rhapsodizes over the virtues of emerging-markets debt and currencies. The world's five largest developed economies generate 40% of the world's gross domestic product and account for 70% of all government debt. The world's 160 emerging nations account for the same percentage of global GDP but just 10% of debt. "The risk of default is much lower in emerging markets," Arnott says. What's more, emerging-markets bonds boast much higher yields than bonds in the healthier developed nations. As emerging economies continue to grow, their currencies are likely to strengthen, too. "I love emerging-markets currencies long-term," Arnott says. Advertisement He also loves junk bonds, which yield close to 7%, representing extra compensation for the above-average default risk of their issuers. Those yields are actually frighteningly low by historical standards, but high compared with current Treasury yields. Arnott figures that default rates will run only about 2% annually, even though his models suggest a 40% chance of a new recession in the U.S. within the next three to six months. He also likes floating-rate notes. Arnott has 12% of All Asset in commodities, about 6% in developed-market stocks (including all of 1% in the U.S.) and 7% in investment-grade bonds. All Asset's allocations have changed dramatically over the years. Arnott adapts the fund to his current thinking and to what his models tell him. All Asset All Authority is similar to All Asset, but it allows Arnott to use borrowed money to boost his bets by as much as one-third, as well as to use Pimco short funds -- that is, funds that will go up if an asset falls in price. All Authority is too risky for my tastes. All Asset gives Arnott plenty of opportunity to express his strong and independent views. Advertisement As the fund's allocations suggest, Arnott is bearish on the developed world. "Low market returns and slow economic growth will go on for a generation from here," he says. "A lot of it is demographics. As a result, our allocation is far outside the mainstream." I disagree with his long-term outlook (see Why Bill Gross Should Stick to Bonds). But I think Pimco All Asset is a worthy fund, in modest doses, to diversify a portfolio. Expect the funds to trail stocks badly during bull markets. (So far in 2012, All Asset has returned 8.9%, and All Asset All Authority has gained 10.4%; the S&P 500 has returned 13.2%.) Emerging-markets bonds and junk bonds tend to advance when stocks do -- but they don't rise nearly as much. I think of All Asset as about halfway between a stock fund and a bond fund. Bottom line: Although Arnott's funds are unusual, I think they're keepers. Steven T. Goldberg is an investment adviser in the Washington, D.C. area. Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. 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