The equity market volatility of 2020 tested the belief that active equity managers are better equipped to navigate periods of market stress than their passive peers. The performance of active equity managers did little to substantiate this belief, as the percentage of managers that outperformed their passive peers decreased during the year. But there are other solutions. In this Q&A, we explore how active bond management can serve as an efficient, cost-effective approach to generating alpha in equity allocations.
Q: How does the StocksPLUS methodology work, and why should clients consider StocksPLUS for their equity allocations?
A: StocksPLUS offers a unique solution for investors’ equity allocations that seeks to generate alpha in bonds rather than stocks. With the vast majority of active equity managers underperforming their benchmarks, we see a clear need for clients to consider capital-efficient approaches to improve the level and consistency of alpha in their portfolios.
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 with equities leads to the logical question: Why not look beyond traditional stock picking in the search for alpha in equity portfolios? The StocksPLUS methodology does exactly that.
We start by providing efficient exposure to an investor’s desired equity index by buying equity index futures or swaps. We seek to operate in the most liquid futures and swap markets, which offer time-tested and transparent means to achieve equity beta with a low capital commitment. In this way, we free up investment capital to pursue excess returns through a flexible, high quality bond alpha strategy that taps the deeper opportunity set of the global fixed income markets.
Q: What benefits does the StocksPLUS strategy offer equity investors, and how are clients using the strategy?
A: We believe StocksPLUS is well-positioned to help clients invest in line with their long-term horizons, while offering a diversifying source of excess returns.
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 shifts in the yield curve to changes in spreads. The dynamic nature of these portfolios, which do not rely on any single risk factor and maintain a focus on diversification, has been a key factor in the StocksPLUS strategies’ success.
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 over long periods of time. We benefit from our deep risk management and portfolio analytics teams, which support us in taking a disciplined approach to tapping investment opportunities. We do not look to add alpha through gross equity leverage or market timing; StocksPLUS portfolios maintain equity exposure equal to approximately 100% of the portfolio’s overall market value at all times.
One of the additional benefits of the StocksPLUS strategy is that it is highly customizable – both the strategy’s equity beta and bond alpha engine can be tailored to meet clients’ specific needs. We have increasingly seen investors apply the StocksPLUS strategy to a variety of equity betas across geographies, market capitalizations, and benchmarks. In addition, we work with many investors to tailor the bond alpha strategy to achieve their desired risk/return profile while implementing any custom guidelines or restrictions. Given the flexibility of the StocksPLUS approach, clients have used the strategy in various parts of their portfolios – often as a replacement for traditional equity active management.
Q: What sets PIMCO apart as an investment partner in capital-efficient strategies like StocksPLUS?
A: While StocksPLUS is relatively simple in construct, in practice there can be significant implementation complexities. We believe that PIMCO’s depth of resources, robust risk management program, and decades of experience successfully implementing StocksPLUS are a testament to the firm’s ability to navigate these challenges.
Our StocksPLUS strategies are fully integrated solutions, requiring us to optimize liquidity and potential excess returns. While the return of the bond alpha strategy is a key determinant of whether the StocksPLUS strategies outperform, our pursuit of alpha takes into consideration the strategy’s equity overlay. The bond alpha strategy underlying StocksPLUS is explicitly designed with the goal of outperforming the financing cost of equity index exposure while remaining largely uncorrelated with equities. In addition, significant emphasis is placed on liquidity in the bond alpha strategy in order to be able to accommodate margin calls for the equity beta overlay.
Given the need to maintain liquidity while also seeking returns, PIMCO’s vast global resources allow us to construct a high quality bond portfolio with diversified sources of return. Opportunities in bonds continue to be available, and given PIMCO’s 50-year history as a premier fixed income manager, we believe we are an able partner to seek to extract returns in this market.
Although the relevance of the equity beta overlay is sometimes downplayed, it is an important building block for the success of StocksPLUS. We have a team of equity traders who seek to obtain consistent market exposure at the lowest possible cost and support our portfolio management team in comparing financing costs across futures and swaps, sourcing bids from multiple approved counterparties and across tenors, and continuously monitoring PIMCO’s financing costs relative to market costs. We have a counterparty risk committee that is responsible for approving and monitoring high quality counterparties. Given our size and relationships across dealers, PIMCO’s average financing costs are often below market averages. Lastly, we rebalance notional beta exposure daily as the net asset value of our bond alpha strategy fluctuates.
The StocksPLUS approach has been tested through four significant equity bear markets, with a more than 35-year track record and nearly $36 billion in assets under management as of 31 March 2021 – so despite its nontraditional nature, it’s no fad. We have confidence that StocksPLUS and other capital-efficient strategies can continue to seek to deliver strong results for investors in the years to come.
Q: How did StocksPLUS navigate the market environment in 2020?
A: In 2020, we saw the fastest stock market decline on record, which was the ultimate test for a strategy like StocksPLUS. Our robust risk management process, thoughtful portfolio construction, and focus on liquidity management allowed StocksPLUS to weather the extreme market volatility, and eventually finish 2020 ahead of benchmarks.
The first quarter of 2020 presented unprecedented challenges to fixed income markets as the spread of COVID-19 and the introduction of nationwide lockdowns caused even the safest parts of fixed income markets (U.S. TIPS, agency MBS) to underperform Treasuries, resulting in significant market dislocation.
Against this backdrop, the strategy’s bond alpha portfolio experienced mark-to-market losses in March. However, due to the high quality of our holdings and robust liquidity management, the portfolios were not forced to sell and lock in losses. As unprecedented fiscal and monetary policy helped to stabilize markets, the portfolio rebounded after the first quarter, delivering positive alpha for the year.
A number of diversified risk factors drove performance in 2020, including exposure to U.S. rates, agency and non-agency mortgage holdings, corporate and high yield credit allocations, and exposure to developed market inflation. These diversified sources of return demonstrate the strategy’s flexibility to tap into global fixed income markets and use active management to outperform, even in periods of extreme market stress.
Notably, we manage the StocksPLUS bond alpha portfolio to have a low correlation to equities and fixed income markets, which may provide diversification benefits in the event of market stress. For example, when equities rapidly sold off in early 2020, exposure to U.S. duration acted as a risk-off hedge given its negative correlation to equity markets over long time horizons.
Q. What is the outlook for the strategy going forward?
A: We believe StocksPLUS is well-positioned to continue providing a consistent, diversified source of excess returns. In light of the improving market environment and strong support from the Fed, we have modestly increased overall portfolio risk in a balanced manner. In particular, we expect to see more tactical shifts and relative value-oriented strategies.
StocksPLUS has a 35+ year track record and has navigated a wide range of market environments, including the global financial crisis, taper tantrum, and COVID-19 recession. Given the pull-to-par effect in fixed income, periods of underperformance are often followed by periods of outperformance as we saw play out again in 2020. We are confident in the strategy’s continued ability to provide investors with a consistent, diversified source of excess returns.