PIMCO | PIMCO’s Long/Short Equity Strategy

PIMCO’s Long/Short Equity Strategy

For many investors, stock market exposure represents an important expected driver of long-term capital appreciation. However, equity markets do not always deliver positive returns and often are characterized by periods of high volatility. Consequently, many investors seek strategies that will provide exposure to the long-term growth benefits of owning stocks, while allowing for better downside risk mitigation.

To meet these needs, PIMCO has introduced a long/short equity strategy which aims to provide a positive return with lower volatility than the equity market over the long term. Although the strategy does not explicitly aim to manage short-term volatility, it has greater ability than many traditional long-only strategies to manage downside risk, which provides the opportunity for strong risk-adjusted returns over a full market cycle.

The PIMCO Long/Short Equity Strategy is a concentrated, long-biased equity strategy with the ability to actively manage equity market exposure by adjusting the portfolio’s mix of long and short equity, and cash or cash equivalent positions. The strategy, which has nearly a 10-year track record, uses both top-down and bottom-up analysis to construct a high-conviction portfolio of long positions with selective shorts. The strategy’s concentrated and deeply researched equity portfolio looks to capture and magnify gains when markets rise. At the same time, the strategy has greater ability to manage downside risk given its flexibility to hold cash and selectively short stocks. Unlike many strategies that have a limited ability to raise significant cash, let alone short, the strategy’s flexible approach facilitates access to additional sources of alpha and can result in reduced correlation with broader equity market indexes.

Investment philosophy

We believe that a combination of fundamental bottom-up and top-down research, and an opportunistic approach to trading, provides potential for participation in the market upside while maintaining a focus on avoiding the downside during extended market declines. When we believe the opportunities for reward outweigh the risks, we can put capital to work and seek capital appreciation. But when the risks of loss appear to outweigh the rewards, we can raise cash or take other steps to preserve capital. Essentially, the strategy aims to capture most of the market’s gains in up years while avoiding the downside during extended market declines. Under normal market conditions, the portfolio is net long and concentrated in about 20 of our best ideas, with a select number of short positions. In addition to stock selection, active management of the portfolio’s mix of long, short and cash positions is a crucial component of the strategy and its ability to navigate various market environments.

Investment process

The investment process has been in place since Geoffrey Johnson began managing the strategy in 2003. It begins with an assessment of the prospects for the equity market, which is now informed by PIMCO’s economic outlook as well as our judgment on equity market valuations. When we have a positive view of economic and market prospects we tend to be more invested, sometimes fully invested. However, when confronted with what we believe to be a weakening economy, significant financial system risks or unattractive valuations, we are able to raise cash, short or otherwise reduce the portfolio’s exposure to the market.

Our market exposure is guided by PIMCO’s macroeconomic outlook as well as our views on the equity markets. If we think market or financial system risks are too high, the portfolio is likely to carry more cash and selectively short. When our market outlook is positive and we have high conviction in the companies we own, we are likely to put capital to work and have few short positions.

Portfolio holdings are selected based on extensive fundamental analysis, which includes conducting field research, meeting with management teams, analyzing corporate filings, and constructing financial models. Our objective is to identify hidden value and mispriced securities.

The core portfolio of long positions consists primarily of fundamentally strong companies that we believe are attractively priced. We seek to invest in companies with defensible brands, significant cash flow, sustainable earnings growth, and which are capitalizing on secular trends. Once we have identified the right company, we are disciplined about investing at an attractive price. We conduct cash flow or asset-based valuation analysis to determine a company’s true economic value, seeking to uncover stocks with hidden value. If we identify a catalyst that we believe will unlock that value in the next one to two quarters, we will initiate a position.

We short stocks when we identify an opportunity to generate alpha as opposed to simply hedge risk. Companies we short tend to fall into two categories: Fundamental shorts, or companies in secular decline, and cyclical shorts, or businesses that will be impacted the most when the economy is weakening.

When our outlook is bearish and our objective is to hedge, cash management usually is our first line of defense. In bear markets, the strategy can go 100% into cash and cash equivalents to avoid downside risk. To help preserve investors’ capital, in September 2008, for instance, the strategy was invested mostly in cash and cash equivalents.

An experienced investor with a time-tested strategy

Portfolio manager Geoffrey Johnson began executing this strategy in 2003 at Catamount Capital Management, a boutique investment firm where he also served as a managing partner. In April 2012, PIMCO acquired Catamount’s flagship strategy and incorporated its nine-year track record into the PIMCO Long/Short Equity Strategy, which is a continuation of the investment process Geoffrey began at Catamount.

Applications for the strategy

The approach is consistent with the needs of many investors who are moving away from benchmark-oriented strategies in favor of highly active, unconstrained approaches that seek to limit downside risk. Although the strategy aims to deliver attractive returns over a full market cycle, investors should not expect positive returns in every market environment, especially over short-term periods. At times, we would be willing to sacrifice some upside in order to avoid large losses. This is different from an approach that is simply focused on beating the market, such as a 130/30 strategy or a market neutral strategy, that remains hedged at all times. By design, the portfolio will have periods of high volatility in the short term, but its downside avoidance should result in lower volatility than the equity market over the long term.

PIMCO’s approach to managing equities

PIMCO’s approach to active equity investing focuses on providing investment solutions where we believe we can provide a unique value proposition for investors, rather than attempting to be “all things to all people.” This starts with not being constrained by a traditional equity “style box” approach, nor by strict adherence to investing in relation to any given benchmark. We believe a benchmark-agnostic approach and a focus on downside risk mitigation is crucial for generating attractive long-term risk-adjusted returns.

Advantages of long/short equity investing

The PIMCO Long/Short Equity Strategy offers enhanced return potential and downside risk mitigation. It benefits from an ability to invest in a broad, unconstrained universe and attempts to generate alpha on both the long and the short sides of its portfolio. Additionally, it has the flexibility to raise cash in an effort to preserve capital during market declines.

How To Invest

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. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in securities of smaller capitalization and mid-capitalization companies tend to be more volatile and less liquid than securities of larger companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. PIMCO strategies utilize derivatives which 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 is suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

This material contains the opinions of the manager 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.

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