Conventional wisdom has held that smaller capitalization stocks can offer potentially higher returns because they tend to be less well covered by analysts (thereby increasing the chances that they may be mispriced) and also tend to be less liquid and more volatile than their large cap counterparts. As a result of all these factors, there are typically more opportunities to uncover hidden gems in the small cap market than there are in larger capitalization markets.
Consequently, many investors look to active managers to navigate this segment of the U.S. stock market. In fact, our research shows that active small cap managers oversee more than five times the amount invested in passive vehicles such as index funds as of March 31, 2011. Given that many active managers in this space have produced market-beating returns, it shouldn’t be terribly surprising that they tend to be more common than passive approaches.
However, some active managers can become victims of their own success: As a result of outperformance, they may gather such large amounts of assets that they lose their agility to maneuver the typically less liquid small cap universe. In fact, from January through July 2011, a total of twelve small cap managers closed their strategies to new investors because they had grown so large – twice as many as during the full year 2010, according to Morningstar. While these managers closed their doors to new investors, others continued to accept new assets and pick up the slack, thereby running the risk of also losing their potential edge and producing index-like returns.
Index investing is certainly a viable option for investors looking for small cap exposure, but like all pure passive strategies, the best outcome an investor can expect is the index return minus fees.
Incorporating a Derivatives Solution
While many investors take this indexed approach through one of the many modestly priced offerings in the marketplace, we believe that there is a more effective approach to small cap investing – one that does not have to sacrifice excess return potential (like index approaches do) and is not limited by liquidity constraints: Adding exposure to small cap stocks through equity index derivatives such as Russell 2000 Index futures contracts is a potentially attractive and often overlooked solution for investors looking either to adjust allocations to existing small cap investments or make new investments to this segment of the market.
PIMCO’s Small Cap StocksPLUS Total Return strategy is one such example of this approach. By combining Russell 2000 Index futures and/or total return swaps to gain exposure to small cap stocks, and by backing those derivatives with a fixed income portfolio, the Small Cap StocksPLUS Total Return strategy offers the potential to deliver attractive excess returns that are not materially correlated with managers who employ active stock selection. Because the strategy does not involve direct investment in actual small cap stocks, Small Cap StocksPLUS Total Return does not face the same capacity constraints that may limit other managers from accepting additional assets.
Small Cap StocksPLUS Total Return
Our Small Cap StocksPLUS Total Return strategy seeks to capitalize on PIMCO’s depth of experience: We have managed the broader StocksPLUS strategy for 25 years and Total Return portfolios for 40 years.
The goal of StocksPLUS Total Return is to deliver consistent excess returns relative to a given equity index over three- to five-year time horizons. The StocksPLUS Total Return strategy uses equity index futures, and sometimes swaps, to achieve non-leveraged passive stock market exposure -- thereby eliminating the risk of underperformance due to adverse stock selection relative to the index. As equity index ownership using futures and swaps typically only requires a very modest initial cash outlay (or margin), PIMCO invests the remaining cash in an actively managed total return style core bond portfolio with low to intermediate duration, with the goal of outperforming the money market interest rate cost typically associated with equity index futures and swap ownership.
We manage our StocksPLUS Total Return strategy with a more flexible approach to duration than our regular Total Return bond portfolios, which may help limit underperformance during periods of sharply rising interest rates. In essence, if the Total Return bond portfolios outperform money market rates, StocksPLUS Total Return strategy could be expected to deliver excess returns to its investors.
In the case of the Small Cap StocksPLUS strategy, we are able to tap into an additional (and very attractive) potential source of structural alpha. The Russell 2000 Index futures contract that we use to gain U.S. small cap stock exposure has historically traded cheap relative to its fair value and thus has allowed us the opportunity to provide even greater value to our clients.
Why Russell 2000 Index Futures?
We have observed that Russell 2000 futures contracts have the potential to offer additional value compared to futures contracts that we employ in other StocksPLUS strategies. Most futures and swap markets typically provide the return of the equity index, less a money market rate. The combination of index arbitrage and market convention is the reason behind this. However, there is a unique effect caused by the smaller, less liquid nature of small cap stocks, which makes investing in the Russell2000 index futures contracts so attractive to many investors.
Let’s say an investor wants to capitalize on a pricing differential between two small cap stocks. It’s easy enough to buy the desirable stock, but tends to be very difficult in practice to establish the short position. Why is this the case? Think about the mechanics of a short sale: one needs to find an available block of shares to borrow, sell, and buy back at (hopefully) a lower price. Finding the shares to borrow can be more difficult and costly in the less liquid small cap equity market, so many investors prefer the convenience of hedging using index futures and swaps. In other words, common practice among investors looking to express long/short strategies – mostly hedge funds – is to buy stocks and attempt to hedge out the market exposure by shorting futures or swaps.
This may work out to be an advantage to the investor who wants small cap exposure and can achieve it by going long futures or swaps. Arbitrageurs would be unable to take advantage of this mispricing as it would require going long the futures and simultaneously short selling all the 2,000 stocks in the index. Given the liquidity and short selling constraints described above, this is typically not a feasible strategy. As a result, the Russell 2000 index futures tend to trade “cheap” and thus can offer a potential return advantage to investors who maintain long positions. As shown in Figure 1, the “cheapness” has tended to be persistent (note that bars beneath the line are additive to performance).
The bottom line: we have found that Russell 2000 futures typically involve an implementation cost that is cheaper than those observed in other equity futures markets. The PIMCO Small Cap StocksPLUS Total Return strategy strives to take full advantage of this structural inefficiency.
Portfolio Implications
We believe the PIMCO Small Cap StocksPLUS Total Return strategy can be a compelling way to gain exposure to the U.S. small cap market, combined with the opportunity to generate consistent excess returns over the Russell 2000 Index. Unlike many other small cap strategies, Small Cap StocksPLUS Total Return has historically offered a high degree of liquidity and capacity. The Russell 2000 futures and swap markets are large and liquid, as are the fixed income markets we typically invest in. So, in contrast to other active managers in this space, we do not anticipate capacity constraints.
Our approach to seeking excess returns tends to be completely unrelated to the way other active equity managers typically try to beat the market. We pursue structural, yield-based sources of excess returns, which we believe may provide an attractive complement for traditional active management, or even a substitute for traditional active management. We call alpha sources “structural” when they show historical evidence of being highly consistent and diversifying in nature. When combined with other active managers, the potential diversification benefits may be pronounced. Our analysis of the StocksPLUS Total Return Strategy’s monthly excess returns versus the median excess returns of the Mercer Small Cap Universe supports our assertion that alpha sources tend to be uncorrelated, with a correlation coefficient of -0.14 since the strategy’s inception (from March 31, 2006 through June 30, 2011).
In short, investors may find the Small Cap StocksPLUS Total Return strategy attractive as either a standalone solution to add small cap exposure, or they may want to incorporate the strategy into a diversified portfolio of other active small cap strategies. Either way, we believe our strategy offers an innovative approach to addressing the challenges typically associated with small cap market liquidity and the constraints of index investing.
Justin Barnum (equity team associate) and Klaus Thuerbach (Wharton MBA summer intern) made significant contributions to this Featured Solution.