Global equities have returned an astounding 13% per year since markets troughed in 2009.1 But generating these levels of returns is likely to become far more challenging going forward, given elevated valuations and an aging bull market – just as global central banks begin the slow process of withdrawing extraordinary monetary accommodation. 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 manager Mohsen Fahmi explains 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 M&A 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. 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 I 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 ~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 assemble 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, in January 2016, as funding costs for equities became historically cheap, we looked to lock in funding for a longer period than we might otherwise. 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 seeking 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 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 does a typical “day in the life” of strategy management look like for the StocksPLUS strategies?
A: We are always looking for the most attractive investment opportunities for these strategies, whether that means U.S. government debt, credit, asset-backed securities or international bonds – and to do this we consistently draw on PIMCO’s vast resources in managing the StocksPLUS strategies, including our dedicated equities trading desk, global fixed income trading desks and investment teams from Newport Beach to Tokyo to London and Munich.
On a typical day, we may start by reviewing key portfolio risk factors and allocations and talk to our short-term desk about needs to raise or invest cash. We’ll review overnight markets in Asia and connect with our London-based team on activity in European rates, currencies, spread markets and updates on the policy front. We may then engage with the emerging markets team about a political development in Brazil or a new issue in Argentina or a currency position in Mexico. This may be followed by a call with the credit team to discuss their outlook on financials, and then a huddle with the securitized team to discuss a new CLO offering – and all of this could happen before lunch. The team’s participation in PIMCO’s Investment Committee leads to further discussion and debate. This breadth of resources opens up a truly vast opportunity set.
The strength of the process lies in our ability to combine top-down views with bottom-up opportunities. What it all comes down to is highly robust portfolio construction that does not just reflect one position or view, but rather adapts to different market conditions, whether rates are rising or falling.
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 – 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.
1 Global equity returns proxied by the MSCI ACWI (All Country World Index).