PIMCO’s StocksPLUS Strategies

Improving on the performance of broad equity indexes can be a significant challenge in today’s highly efficient markets, where information spreads quickly and is incorporated into stock prices virtually instantaneously.

But maximizing the return from equities may be particularly important because stocks typically comprise a meaningful percentage of investor portfolios. Active equity management is one possible solution, but it is notoriously difficult to consistently beat the market through individual stock (or sector) selection. Deviating from the equity strategy of “owning the market” also introduces new risks that are difficult to quantify, raising the risk of underperforming the market by a potentially significant amount at a time when equity and other asset class returns may be lower overall.

To meet the challenge of outperforming highly efficient equity markets on behalf of our investors, PIMCO developed the original StocksPLUS strategy over 20 years ago, and since then has expanded the product line to include a number of variations of StocksPLUS designed to meet different investor preferences and objectives.

PIMCO’s StocksPLUS strategies seek to add value to the equity market return by employing PIMCO’s full set of skills as a global fixed income manager, including the ability to capitalize on structural inefficiencies in the fixed income markets. Importantly, the value added proposition is largely independent of the equity index benchmark selected and can be applied to a number of major equity indexes around the world.

PIMCO’s Approach: Equity Futures Backed by Actively Managed Fixed Income

The StocksPLUS strategies fit into what is more broadly known as ”portable alpha,” a term that is generally applied to strategies in which the desired asset class exposure, often referred to as “beta”, is obtained synthetically thereby allowing risk-adjusted returns or “alpha” to be sourced from an entirely distinct asset class or active management strategy. Some of PIMCO’s StocksPLUS strategies avoid the risks associated with individual stock selection by “owning the market” through equity index futures contracts and/or swaps.

Equity futures and/or swaps provide the portfolio with exposure to the underlying index as if all of the portfolio’s assets were invested in the individual securities that make up the index, but only require a modest initial margin deposit up front to obtain the index exposure. This leaves the majority of the cash available to be invested in an actively managed fixed income portfolio.

Because the equity futures and swap contracts are priced such that a combination of futures and money market investments (which should provide a return that offsets the financing cost of the futures) should produce a return equal to that of the index, PIMCO seeks to achieve a total return on the fixed income portfolio that exceeds money market rates, thereby generating an incremental return over the equity market index.

As can be expected with any strategy that assumes active risk in an attempt to outperform, StocksPLUS strategies may deliver below index returns in certain environments. For example, sharply rising short-term interest rates, a flat or inverted yield curve or widening yield spreads on corporate and mortgage-backed securities can affect PIMCO’s ability to add value in the StocksPLUS strategies.

A Variety of StocksPLUS Strategies for Different Needs

As noted above, PIMCO offers several versions of StocksPLUS to suit investors with different goals and risk tolerances. In terms of fixed income-based sources of alpha, we offer several different strategies, summarized below.

All of the StocksPLUS strategies seek to capitalize on two of PIMCO’s core strengths: the efficient management of derivatives positions and the effective management of a fixed income portfolio. PIMCO is among the most sophisticated investors in derivative instruments and has invested in fixed income since the firm’s inception in 1971.

PIMCO has also expanded the variety of equity index exposures available to investors as part of the strategy. The product was introduced in 1986, when trading in equity index futures was developing. At that time, the S&P 500 contract was the prevalent means of obtaining index exposure through derivatives. The S&P 500 remains a key component of many StocksPLUS strategies, but the PIMCO StocksPLUS mutual fund line also includes equity index exposure to the Russell 2000 Index via the PIMCO Small Cap StocksPLUS TR Fund.

In addition, PIMCO also offers exposure to a proprietary portfolio of stocks selected by sub-advisor Research Affiliates with the goal of generating excess returns relative to the FTSE RAFI 1000 index. Research Affiliates uses an enhanced form of the fundamental factor-based stock selection process that underlies their fundamental indexation research. The end result with PIMCO’s Fundamental IndexPLUS strategies is the first portable alpha equity strategy to offer investors two independent sources of alpha – stock selection and active fixed income management – for every unit of capital invested. The Enhanced Fundamental Index equity exposure is available in the following mutual funds:

PIMCO Fundamental IndexPLUS Fund (Enhanced Cash)

PIMCO Fundamental IndexPLUS TR Fund (Core Plus Bonds)

The stock selection alpha process and the PIMCO fixed-income based alpha process are likely to exhibit no material correlation. This should result in an additional diversification benefit.

The Advantages of PIMCO’s StocksPLUS Approach

PIMCO’s StocksPLUS approach can offer several specific advantages over active equity management.

For starters, StocksPLUS offers the potential for excess returns based on structural advantages which exist in the bond market, rather than stock-picking prowess. Unlike highly efficient equity markets, fixed income markets persistently offer a number of structural advantages which can translate into excess returns on a relatively consistent basis. The four most common bond market inefficiencies include the term premium, credit premium, liquidity premium and volatility premium. For each, investors with a longer time horizon or higher risk tolerance than money market investors may be rewarded for stepping out of the money market universe and accepting the incremental risk and return associated with each of these premia. Excess return potential from structural advantages may be more reliable over longer-term horizons than an approach which relies on continuously picking the winning stocks of tomorrow.

By contrast, active equity managers face the efficient markets hurdle, the cash vs. full exposure dilemma, higher transaction costs and presumably the need to outperform their fees. All of these factors make it difficult for active equity managers to add value consistently in all market conditions.

StocksPLUS strategies may benefit further from capturing both the dividend yield of the equity index and yield provided by the underlying fixed income portfolio—and yield may be a particularly important component to returns in a prospective environment if price gains are relatively modest and equity dividend rates are at historic lows.

A key characteristic of the StocksPLUS approach is that the strategy may offer these excess returns with a very stable beta to the desired equity index. In contrast, many stock-selection based strategies and portable alpha strategies which employ alpha programs with significant equity market correlations may deliver betas materially different than 1.0, and possibly during inopportune environments. The StocksPLUS strategies may maintain a consistent beta across different market environments due to the general lack of correlation between equity markets and fixed income markets.

Similarly, StocksPLUS alpha will likely exhibit low or even negative correlation with any alpha generated by traditional active equity management strategies. Investors would not expect the fixed income oriented StocksPLUS alpha to have any relationship to benchmark-relative returns derived from stock-selection.

For investors focused on liability management, PIMCO StocksPLUS Total Return Fund may deliver returns with a positive correlation to pension plan or other longer-dated liabilities. As a result, returns could be higher when liabilities are increasing and lower when liabilities are falling.

Taken together, these advantages suggest PIMCO’s StocksPLUS strategies may consistently and systematically outperform an actively managed equity portfolio over the long-term investment horizon.

Conclusion

PIMCO’s StocksPLUS strategies are designed to provide the returns of the broad equity market plus a consistent additional return over and above the return of the equity market. We aim to achieve this by using equity futures and/or swaps to provide exposure to the performance of a given equity index with a minimal or no cash investment. The remaining portfolio assets are invested in a fixed income portfolio with the goal of outperforming the money market financing rate of equity derivatives through active management and structural inefficiencies in the bond market. The StocksPLUS approach can be applied to many major equity indices around the world, with varying degrees of risk and expected return available from the range of StocksPLUS strategies.