| The StocksPLUS investment philosophy is based on our belief that equity index futures offer an efficient, relatively low-cost way for investors to obtain equity index exposure. Much like an investor who replicates a given equity index by purchasing all of the stocks in the index, an investor who purchases equity index futures should receive the returns provided by the index. However, while stock purchases generally require payment of the entire cash investment amount in exchange for the stock index exposure, the cash outlay required to gain exposure to a given equity index using futures contracts is generally quite low (approximately 5% – 10% of the total contract value for S&P 500 futures contracts, as an example). This allows the remaining cash to be invested in a diversified “enhanced cash” portfolio. Of course, because the investor is not required to pay for the entire equity exposure upfront, as is the case with most “buy now and pay later” arrangements, there is an interest rate cost associated with equity index ownership using futures and/or swaps. Equity index futures provide the total return of the equity index in exchange for the payment of a short-term money market interest rate that is embedded in the price of the futures contract. Therefore, if the cash retained with the equity index futures purchase is deposited in a short-term money market account that returns a rate equal to the interest rate paid, in theory the investor will receive the total return of the equity index. However, if PIMCO is able to actively manage the cash and consistently achieve returns higher than the money market interest rate paid, then StocksPLUS should be able to outperform the equity index on a consistent basis. In some cases, total return swaps may provide a largely equivalent way to obtain equity exposure. Both total return index swaps and index futures contracts generally require very little or no cash required at the time the equity exposure is obtained and the investor subsequently receives the total return of the equity index in exchange for the payment of a money market based interest rate (generally LIBOR +/- a spread). |
| PIMCO looks to multiple sources in an effort to outperform the short-term money market interest rate embedded in the price of equity index futures and/or swap contracts. Money market investors are generally seeking perfect liquidity and principal preservation over very short time periods, and in exchange, are willing to accept materially lower yields and expected returns than the yield/expected return provided by other fixed income instruments. Conversely, equity investors tend to have much longer time horizons. As a result of this longer investor time horizon, combined with PIMCO’s broad, deep, active fixed income management skill set, we think that it is appropriate to hold a diversified enhanced cash portfolio of high quality securities, including securities that may provide attractive yield premiums relative to money market rates. We believe that there are at least four structurally based yield premiums that are available in the vast majority of market environments:
- The term premium: The yield premium provided by securities with maturities greater than the typical short maturity of money market instruments. Generally speaking, fixed income securities with longer durations have greater yield premiums – all else equal – as exhibited by the typical upward sloping nature of the Treasury yield curve
- The transactional illiquidity premium: The yield premium provided by fixed income instruments that, unlike money markets, do not settle on a same day or next day basis at a minimal bid/ask spread
- The credit premium: The yield premium provided by most securities that are not issued by government or government agency entities
- The volatility premium: The incremental yield earned by investors willing to hold securities that are subject to greater price volatility than typical money market instruments for a reason other than the three factors listed above
In our view, the most efficient duration management strategy involves at least a modest extension of duration beyond the average time to expiration of the most liquid equity index futures contracts in order to capture the term premium offered by the positively sloped shape of the yield curve under normal market conditions. Except in extreme cases, the higher yield obtained through duration extension and active management may offset any potential decline in the prices of our fixed income holdings due to rising interest rates over periods of reasonable length. Additionally, as we limit our portfolio duration to one year, we seek to avoid excessive sensitivity of StocksPLUS returns to changes in interest rates.
In addition, rather than invest the entire portfolio backing the equity futures in money market instruments, we believe that a portion of a StocksPLUS portfolio should be invested in higher-yielding, slightly less liquid (than money markets) securities, given a long-term investment horizon. These issues tend to earn a higher yield due to their lower trading liquidity. However, because our holdings are generally short-term issues, they are mostly self-liquidating. Thus, market participants who actively trade these bonds, in effect, subsidize PIMCO’s clients who act as long-term holders via StocksPLUS. Importantly, we generally maintain a significant portion of the portfolio in securities we feel can be liquidated quickly at a moderate cost, in an effort to ensure sufficient liquidity to meet margin flows even in a dramatic stock market decline.
Another potential source of value added in StocksPLUS portfolios is obtained by investing a portion of the portfolio in corporate fixed income, asset-backed, and other securities to capture both yield and diversification benefits. Effective use of these securities adds return potential to the portfolio with relatively modest incremental credit risk, given the short-term nature of the majority of these holdings. While PIMCO primarily focuses on the investment grade segment of the corporate bond market and intends to maintain a minimum portfolio credit quality of B to Aaa, we may invest up to 10% of assets in below Baa securities in Full Authority StocksPLUS portfolios.
An additional source of extra potential return in StocksPLUS portfolios is provided by the market in the form of a volatility premium. Investors typically overpay for price stability as demonstrated by the fact that implied market volatility is generally higher than actual realized volatility. Therefore, by effectively selling a volatility hedge PIMCO seeks to exploit this market inefficiency and capture the underlying premium for StocksPLUS portfolios. An example of a strategy that is consistently employed in StocksPLUS portfolios to capture this volatility premium includes buying and holding mortgage-backed securities.
In addition to the structural sources of potential excess returns in StocksPLUS portfolios, we believe that our active fixed income skill set is key to success in the StocksPLUS strategy – a skill set which we have carefully honed over our nearly four decade history as a fixed income manager.
PIMCO’s active fixed income management skill set and broad market coverage together with the aforementioned yield premiums made possible by long-term holding periods of our investors add up to a wide variety of opportunities for PIMCO to add value. |