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Andrew F. Pyne, Sabrina C. Callin
While equity markets have benefitted from aggressive central bank activity and signs of recovery, we believe slowing global growth and deleveraging are likely to result in lower long-term returns for most asset classes, including equities. Unresolved structural problems, particularly in developed economies, and policy uncertainty could also lead to periods of high volatility.
Equities remain an important long-term return driver for investors, but in our view, traditional approaches to building equity portfolios may not be enough. We have found three complementary ways investors can enhance their equity return potential going forward:
Many investors today have strong impressions of equities informed by the high-return markets of the 1980s and 1990s. A benign economic backdrop coupled with declining interest rates provided a tailwind for earnings and drove multiple expansion, resulting in annual returns in the mid- to high teens over 20 years as measured by the S&P 500. In this environment of strong capital appreciation, simply gaining exposure to equity beta, or the market’s return, was often enough for investors to achieve their return targets. This led to higher allocations to passive equity strategies and the development of the style-box framework, which, by prescribing allocations across markets caps and styles, is in effect a systematic way to gain diversified exposure to equities.
However, we believe that simply gaining exposure to equity beta is no longer enough. In this lower-return environment, alpha – return above the benchmark – and diversified sources of return are becoming more important. As a result, investors may need to rethink traditional passive and active equity solutions.
Drawbacks of traditional equity approaches Traditional equity approaches have always presented certain drawbacks for investors, and in a lower return world, we believe these are likely to have a noticeable, adverse impact on portfolio performance.
For starters, contrary to conventional wisdom, passive index investing is not necessarily a lower-risk approach to equity ownership. For sure, passive indexing provides certain benefits, including liquidity, transparency, broad diversification and low cost. But passive index investors have full exposure to market upside and downside: By definition, passive investors will capture 100% of both an up and a down market, which has proven painful in the market declines of the past decade (Figure 1).
Looking forward, we believe alpha will be particularly valuable in helping reduce downside risk and a critical component in achieving higher long-term returns in a higher volatility environment. The negative effects of compounding magnify with volatility: If your portfolio is down 50%, you then need to be up 100% to break even. Since traditional passive approaches do nothing to cushion the downside, they may not be effective equity solutions for navigating the bumpy journey ahead.
The way traditional indexes are constructed can also be problematic. Capitalization-weighted indexes are constructed with price as a key input. It necessarily follows that overpriced stocks and sectors will be overrepresented relative to their intrinsic values and, correspondingly, underpriced stocks and sectors will be underrepresented. And the more distorted the prices of a particular sector or stock become, the greater the ultimate cost to investors should the market correct. Consider the following passive equity investor’s experience over the past 25 years (Figure 2).
While these drawbacks call traditional passive approaches into question, going active also has its challenges. It has long been difficult to identify managers who can consistently deliver meaningful outperformance after fees across different market cycles, especially in the most efficient segments of the market like U.S. large cap equities. But now, this challenge is exacerbated by a noteworthy shift among active managers to become more benchmark-like over time.
Thirty years ago, virtually all equity managers were active or highly active as measured by active share. However, as the focus on benchmarking and tracking error took hold, this changed. Today, traditional active equity approaches, on average, involve significantly lower levels of active risk (Figure 3), making it even more difficult for investors to select managers with the potential to deliver meaningful alpha after fees over the long term.
Option #1: Use fundamental indexing The problem with traditional indexes is that they use only one input in the index construction process – market capitalization – and this input is a function of price. Fundamental indexes instead select and weight stocks based on a variety of non-price measures of company size. By using multiple inputs, rather than one, and by removing price from the construction process, fundamental indexes can avoid the distortions observed in cap-weighted indexes and the associated performance drag.
Importantly, using the Research Affiliates Fundamental Indexes (RAFI) as an example (Figure 4), fundamental indexing may provide investors with a valuable source of additional returns.
Option #2: Take advantage of structurally based, independent sources of alpha Consistent with the idea of alternative approaches to index construction, our second option is an “index-plus” approach that couples equity market exposure with an independent, alternative, structurally based alpha source. In this approach, equity index exposure is obtained synthetically (using futures and swaps) with a focus on minimizing the rate paid for short-term money market financing. The futures and swaps are collateralized by a high-quality, liquid, actively managed portfolio, typically an absolute-return-oriented bond portfolio designed to outperform the short-term rate. If this fixed income portfolio outperforms money market rates and manager fees, then the investor receives the equity market return “plus” this incremental return (Figure 5).
Index-plus strategies offer equity investors a unique opportunity to seek structurally based excess returns by capitalizing on a longer time horizon than that of a money market investor. Because the beta comes from exposure to an equity index and the alpha from exposure to an actively managed fixed income portfolio, they also offer investors the ability to obtain valuable diversification within the strategy itself (between the alpha and the beta) and within a broader equity allocation when combined with stock-selection-based strategies. Index-plus strategies are available for a range of cap-weighted and fundamental index exposures globally, and we believe these approaches offer a prudent way to potentially enhance equity returns.
Option #3: Emphasize active share with stock selection approaches Our third approach relates to stock-selection-based active equity strategies: Investors should choose truly active managers, as defined by active share − the percentage of a portfolio that is different from its benchmark. Active share is an objective, holdings-based metric that effectively reveals a manager’s active risk.
Figure 6 shows that in the global equity fund universe, less than 25% of “closet indexers” (managers with less than 60% active share) outperformed their benchmarks and on average underperformed over the five-year period. For managers with active share between 60% and 90%, less than 45% outperformed, though as a group they did outperform. For managers with active share greater than 90%, more than 60% outperformed and delivered average annual outperformance of 3.6%. While different studies and time periods may produce different results, this study offers compelling data to consider the merits of high active share equity management.
There are a couple of key takeaways here. First, be wary the closet indexer, as you will likely be better off going passive than paying fees for a benchmark-like strategy. And second, to improve equity return potential, use active share in manager selection. We suggest performing deep due diligence on managers, evaluating their people, their philosophy, their process and their resources. And if you conclude the manager’s research is high quality, then ensure they run high active share portfolios. We believe this combination of research quality and high active share can result in meaningful alpha opportunity over the long term.
Bringing it all together At PIMCO, we’ve built equity capabilities consistent with these investment approaches. We have not created traditional benchmark- and style-box-oriented active equity strategies; instead, we offer index-plus, fundamental index-plus and high active share stock-selection-based active equity strategies. We believe these complementary equity strategies are well-positioned to provide the alpha opportunity needed by investors in this more challenging environment.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.
The FTSE RAFI All-World 3000 Index comprises 3000 companies with the largest RAFI fundamental scores selected from the FTSE Global All Cap Index. The FTSE Global All-Cap Index is a market-capitalisation weighted index representing the performance of the large, mid and small cap stocks globally. The index aggregate of around 7,400 stocks cover developed and emerging markets and is suitable as the basis for investment products, such as funds, derivatives and exchange-traded funds. | The FTSE RAFI Emerging Markets Index is part of the FTSE RAFI Index Series, launched in association with Research Affiliates. As part of FTSE Group’s range of non market-cap weighted indexes, the FTSE RAFI Index Series weights index constituents using four fundamental factors, rather than market capitalisation. These factors include dividends, cash flow, sales and book value. The FTSE RAFI Emerging Markets Index is designed to provide investors with a tool to enable investment in emerging markets whilst using fundamental weightings methodology. The FTSE RAFI Emerging Index consists of the 350 companies with the largest RAFI fundamental values, selected from the constituents of the FTSE Emerging Index. | FTSE RAFI™ U.S. 1000 Index is part of the FTSE RAFI™ Index Series, launched in association with Research Affiliates. As part of FTSE Group’s range of nonmarket cap weighted indices, the FTSE RAFI™ Index Series weights index constituents using four fundamental factors, rather than market capitalization. These factors include dividends, cash flow, sales and book value. The FTSE RAFI™ 1000 Index comprises the largest 1000 publicly traded U.S. companies by fundamental value, selected from the constituents of the FTSE U.S. All Cap Index, part of the FTSE Global Equity Index Series (GEIS). The total return index calculations add the income a stock’s dividend provides to the performance of the index. | The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indices included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. | The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. | The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. | Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. | Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. | The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. | It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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