Global equities have returned an astounding 14% per year since markets troughed in March 2009 (based on the MSCI All Country World Index through February 2019). But generating anything close to these levels of returns is likely to become far more challenging going forward, as the late-cycle environment is likely to put downward pressure on equity valuation multiples, and tightening financial conditions may slow profit growth. This outlook should alert investors that simply achieving index-level equity returns may no longer suffice; they will likely increasingly need significant alpha to meet their investment goals. Alas, traditional active equity management (stock-picking) – never an easy task to begin with – has become increasingly challenging over the past few years.
Given these headwinds, investors are realizing that it may be time to rethink their approach to equity investing – and many are looking into nontraditional solutions that go beyond the equity space in pursuit of sustainable alpha. In this Q&A, PIMCO portfolio managers Mohsen Fahmi, Bryan Tsu and Jing Yang explain the unique strategy design behind StocksPLUS, and why it may prove a timely solution for investors seeking a more consistent approach to excess returns at a lower cost than with most traditional active managers.
Q: Why should clients consider StocksPLUS for their equity allocations in today’s market, and how does its nontraditional methodology work to achieve alpha?
A: Given the challenges traditional stock-pickers are facing, we see a clear need for nontraditional solutions like StocksPLUS to seek alpha today.
In recent years, a regulatory and tech-driven democratization of information has made data on companies and market prices readily accessible, chipping away at the value added by active equity managers and creating a much more competitive landscape. At the same time, the opportunity set for active stock-picking has shrunk as increased mergers and acquisitions and a decline in IPOs have made the equity markets more concentrated. In fact, the number of stocks listed on U.S. exchanges is about half of what it was about 20 years ago.
The result is that the vast majority of active equity managers have underperformed their benchmarks over the past decade – and investors have understandably become less confident in their ability to select a high-performing manager. Moreover, looking at past results to select a manager can lead to performance-chasing, which can further erode returns.
The value proposition is starkly different for active bond managers. Our Bonds Are Different research presents compelling evidence that active bond managers can more reliably generate excess returns than equity managers. There are structural reasons for this advantage, including the large proportion of noneconomic bond investors, new-issue concessions for larger-scale buyers and a relative lack of widely available real-time data on the bond markets, to name a few. The stark contrast between the opportunity set for bonds compared to equities leads to the logical question: Why not look beyond equities in the search for alpha? Or, as we like to say, Don’t let your alpha be hostage to your beta choice! StocksPLUS offers an innovative solution for investors’ equity allocations by tapping opportunities in bonds – rather than stocks – to seek alpha.
StocksPLUS’ nontraditional methodology is nonetheless quite straightforward. We start by efficiently replicating the investor’s target equity benchmark performance through equity index futures or total return swaps. We seek to operate in the most liquid futures and swap markets, which offer well-tested and transparent means to achieve equity beta that require a low capital commitment. In this way, we free up around 95% or more of investment capital to pursue excess returns through a flexible, high quality bond alpha strategy that taps the deeper opportunity set of the global macro markets. By managing this active bond portfolio with an aim to outperform the money-market cost of the equity exposure, StocksPLUS seeks to deliver excess returns. And 30 years of history have shown that it can work.
Q: What benefits does the StocksPLUS strategy offer equity investors?
A: We believe StocksPLUS is uniquely well-positioned to help clients invest in line with their long-term horizons while offering a source of excess returns that is uncorrelated with equities.
This suite of products comes in a number of different equity “flavors,” giving clients the flexibility to choose the equity benchmark that aligns best with their goals – whether they’re targeting large cap, small cap, international, emerging markets or even blended or other custom benchmark returns.
The process for alpha generation is one with which most clients are thoroughly familiar. As one of the world’s premier fixed income investment managers, we have access to a broad opportunity set and can draw from the best macro and bottom-up ideas that PIMCO offers. And because we have flexibility in managing the portfolio, we can navigate a variety of ever-changing market environments, from rising rates to yield curve changes to spread widening or tightening. The dynamic nature of these portfolios – which do not rely on any one risk factor and maintain a focus on diversification – has been a key factor in the StocksPLUS strategies’ performance, especially when viewed over three- to five-year horizons.
Some clients may ask whether this strategy amounts to leverage, in that we are providing 100% equity exposure via index-linked instruments as well as managing a bond alpha strategy. While it is clear that we take on risk above the passive equity benchmark risk, we do so in a thoughtful way that pays close attention to portfolio construction. While the concept of StocksPLUS is relatively simple, the key is to deliver excess returns with a bond portfolio that is largely uncorrelated with equities. We benefit from our deep risk management and portfolio analytics teams, which support us in taking a disciplined approach to tapping investment opportunities. And we do not look to add alpha through gross equity leverage or market timing. Because of the way we manage the bond strategy, we seek to deliver a risk profile that is in line with that of an equity index.
We are also cognizant that clients are focused on keeping fees low. Our competitive fee structure allows us to offer StocksPLUS at a significantly lower cost relative to most traditional stock-pickers. And while this strategy focuses on the bond portfolio as a driver of returns, we can also seek to add value by looking at different ways to achieve the equity-replication beta most efficiently at a given time. For example, we may opt to extend the maturity of equity financing to lock in attractive financing rates, or shorten the maturity if we view the funding costs as being less favorable. We can then pass these cost savings on to our investors.
Q: What sets StocksPLUS apart from other PIMCO offerings, and how does StocksPLUS Absolute Return (AR) differ from the original StocksPLUS strategy?
A: What makes the bond strategy underlying StocksPLUS unique within PIMCO is its explicit objective to be uncorrelated with equities in its portfolio construction. Moreover, while traditional bond strategies may be driven by a given benchmark, the StocksPLUS fixed income alpha strategy has no index constraints – it is not a core bond strategy, with the incumbent interest rate risk, or a credit strategy, which may create equity correlations. At the same time, the strategy is wholly consonant with the PIMCO philosophy and investment process: The portfolio benefits from a combination of top-down guidance from our Investment Committee with the flexibility to tap the most promising bottom-up opportunities and relative value ideas.
Both StocksPLUS and StocksPLUS Absolute Return (AR) aim to free up the lion’s share of investors’ capital for investment in a high quality, actively managed bond portfolio that seeks to generate an excess return exceeding the funding cost of the equity replication. The original StocksPLUS strategy seeks to accomplish this by stepping outside of the money-market space to deliver a high quality enhanced cash alpha strategy that is highly liquid under normal market conditions. This approach has a low duration (generally one year or less) and aims to provide a low-tracking-error solution for investors seeking an enhanced index type of allocation.
StocksPLUS AR takes positions that target a higher level of excess return by seeking to capture excessive risk premia and to benefit from medium-term macro trends. The AR strategy looks for the most attractive investments from a global opportunity set and aims to deliver a tracking error very similar to or lower than with traditional active equity strategies. And with a broader toolkit for AR, portfolio construction and position sizing are critically important. For example, when we select a new position to add to the StocksPLUS AR portfolio, we examine how it interacts with the existing bond portfolio and the underlying equity benchmark. Furthermore, when evaluating a new investment position – say, going long U.S. dollars – we pay attention to how to best implement our view. For instance, a long U.S. dollar position against commodity currencies such as the Australian or Canadian dollar may have beneficial defensive characteristics, whereas a long dollar position against the Japanese yen may exhibit detrimental positive equity correlation.
All else being equal, we seek to select positions that may have lower correlations to the equity benchmark and which reduce portfolio concentration risk, thereby positioning StocksPLUS AR in an effort to deliver a more “pure” alpha.
Q: What is the investment process for StocksPLUS? How does the portfolio management team work together and with other parts of the firm?
A: Like all PIMCO strategies, StocksPLUS applies PIMCO’s distinctive top-down and bottom-up investment approach. PIMCO’s investment process begins with our Cyclical and Secular Forums: Four times a year, our investment professionals from around the world gather in our Newport Beach office to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. Cyclical Forums are held three times a year and focus on market and economic trends over the coming six to 12 months; at our annual Secular Forum, we discuss trends over the coming three to five years. These top-down views are complemented by bottom-up insights from PIMCO’s specialist portfolio managers.
PIMCO’s Investment Committee – of which Mohsen is a permanent member – is composed of senior investment professionals. The committee meets several times per week and regularly invites various PIMCO experts to discuss a wide range of topics, including economic data, policy developments, global politics, market trends, live trade ideas from our specialist desks, portfolio reviews with our risk management team, and special topics from our analytics team. The Investment Committee provides guidance to portfolio managers based on forum views and current market developments. These discussions, like our forum process, are global in nature: We are a global firm and look for investment opportunities around the world.
As portfolio managers on the StocksPLUS strategies, we apply PIMCO’s top-down investment views and guidance from the Investment Committee, while also leveraging from the best bottom-up ideas of PIMCO’s specialist teams. Our specialist teams cover every segment of the global fixed income universe, including government bonds, structured products, short-term assets, mortgage-related products, corporate bonds, non-dollar-denominated debt, foreign exchange, emerging market assets, convertible debt, and inflation-protected markets. We interact daily to discuss a variety of topics, ranging from economic data to new trade strategies to ways to optimize different aspects of portfolio construction. We also have a formal weekly meeting to review overall portfolio positioning, assess risk and correlations across portfolio themes, and discuss economic and asset class outlooks.
The strength of the process lies in our ability to combine top-down views with bottom-up opportunities. The result is highly robust portfolio construction that does not reflect just one position or view, but rather adapts to different market conditions.
Q: What sets PIMCO apart as an investment partner?
A: PIMCO has been running the StocksPLUS portfolios for more than three decades, and we have continually honed our process to seek to optimize liquidity and returns. Opportunities in bonds continue to be available, and given PIMCO’s 45-year history as a premier fixed income manager, we believe we’re an able partner to seek to extract returns in this market.
With our global reach, we have access to PIMCO’s best minds to capture and exchange ideas. And the diversified resources available to PIMCO, with traders across the globe, provide access to a broad opportunity set. For institutional or individual investors who may be looking to expand their own investment universe, this offers a key advantage.
The StocksPLUS approach has been tested across market environments, with a more than 30-year track record and more than $30 billion in assets under management as of 31 December 2018 – so despite its nontraditional nature, it’s no fad. We have confidence that it can continue to seek to deliver strong results for investors in the years to come.
Sudi Mariappa also contributed to this paper.