In addition, as both sources of return are expected to exhibit a low to negative correlation with one another and the equity market, the diversification benefits may be compelling.

The stock market alpha is derived from the combination of long exposure to a portfolio of stocks selected and weighted according to fundamental factors and short exposure to the market-cap weighted S&P 500 index. Through this combination, the strategy isolates the potential outperformance of the Fundamental Index while maintaining an equity market neutral profile. Because the long and short equity market exposure does not require a significant capital investment, the majority of the capital invested in Fundamental Advantage is available to be invested in an actively managed fixed income portfolio designed to provide a second source of return and diversification.

Fundamental Advantage is built on the same platform as StocksPLUS, the portable alpha equity strategy PIMCO has managed for over 20 years. However, unlike the increasingly broad set of portable alpha equity approaches that PIMCO now offers, Fundamental Advantage does not provide systematic equity market exposure. Rather, the Fundamental Advantage strategy taps into PIMCO’s established expertise in StocksPLUS in an effort to generate returns that are expected to have little or no correlation with the equity market.

The Stock Selection Alpha Return Source: An Enhanced Fundamental Index
The Fundamental Advantage strategy invests in derivatives which provide a long position in the Enhanced Research Affiliates Fundamental Index 1000 (“Enhanced RAFI”), hedged by a short position in the S&P 500. The return from this combination will equal the return of Enhanced RAFI less the return of the S&P 500.

Enhanced RAFI is a proprietary basket of stocks selected by strategy sub-advisor Research Affiliates, based on the fundamental factor-based stock selection process underlying Research Affiliates’ fundamental indexation research. Enhanced RAFI seeks to outperform the S&P 500 by eliminating the performance drag associated with market-cap weighted indices that systematically overweight overpriced stocks and underweight underpriced stocks.

Research Affiliates takes into account each company’s gross sales, free cash flow, net book value, and gross dividends in formulating the weighting of stocks in the portfolio. Several other proprietary screens are also applied in the construction of the portfolio in an effort to further enhance risk-adjusted return. Selecting and weighting stocks according to fundamental factors captures the economic size of companies and specifically eliminates the influence of stock prices from the portfolio construction process.

The Enhanced RAFI strategy is designed to provide alpha relative to the S&P 500 across most equity market cycles. However, the strongest outperformance may occur at times of equity market weakness, when Enhanced RAFI may benefit from having lower weightings of overvalued stocks that experience significant price corrections. For similar reasons, any periods of material underperformance of Enhanced RAFI relative to the S&P 500 are likely to correspond to strong bull equity markets, such as the tech boom of the late 1990s.

The charts below summarize how RAFI has performed on a historical basis relative to the S&P 500. The FTSE RAFI US 1000 is shown as a proxy for Enhanced RAFI, which includes additional proprietary enhancements provided by Research Affiliates that are designed to improve return potential. As described above, the alpha – or difference between the Enhanced RAFI performance and that of the S&P 500 – has been greatest during weak equity market environments. This component of the Fundamental Advantage strategy may prove to be particularly valuable to investors when their stock portfolios are declining in value.

The Fixed Income Return Source: An Actively Managed Fixed Income Portfolio
As the long and short equity exposures require very little capital, the majority of the cash that an investor allocates to the Fundamental Advantage strategy is available to be invested in a fixed income portfolio that capitalizes on PIMCO’s nearly four decades of active management experience.

For Fundamental Advantage Total Return, the assets are invested in a diversified low to intermediate duration “total return” style portfolio that is not constrained by a traditional fixed income benchmark. The fixed income strategy takes a diversified approach to adding value, seeking to provide greater potential for consistent outperformance by employing multiple concurrent strategies and taking modest risk in each, thereby reducing the risk of poor performance from any single source. The portfolio has the flexibility to expand beyond government securities, mortgage-backed securities, and corporate bonds to include an extensive global fixed-income opportunity set, and actively manages interest rate exposures, invests in non-benchmark sectors, and targets long-term structural premiums in the bond market.

For Fundamental Advantage Tax Efficient, a version of the strategy designed specifically for taxable investors, the assets are invested in an actively managed high yield municipal bond portfolio. PIMCO’s high yield municipal strategy seeks to diversify among all high-yield sectors and generally works to maintain credit quality in the upper ranges of the high-yield municipal sector. Credit selection in the high-yield muni market requires more issuer-specific analysis, and PIMCO integrates both top down macroeconomic views and bottom up issuer-specific research in an attempt to identify the bonds that provide the most attractive yield and price-appreciation potential, as well as the issues most likely to weather an economic slowdown. The yield on the high yield municipal bond portfolio is tax-exempt at the federal level and sometimes state level, and the after-tax returns for taxable investors may be attractive relative to other assets and strategies.

Both fixed income based approaches seek to generate attractive total return performance, including interest income and capital gains, while offering liquidity, capital preservation, and prudent risk management.

Implementation of the Fundamental Advantage Strategy
PIMCO implements Fundamental Advantage by entering into long positions in total return swaps that track the Enhanced RAFI in an amount equal to the portfolio value. At the same time, a equal-sized short position is implemented using S&P 500 swaps and futures. The net return of this combination of equity derivatives is designed to isolate Enhanced RAFI alpha while maintaining an equity market neutral profile.

Equity futures and/or swaps provide exposure to the underlying equity index as if all of the portfolio’s assets were invested in the individual securities that make up the index. However, because swaps and futures require only a very modest initial capital commitment, the majority of the cash invested in the strategy is available to be deployed in the actively managed fixed income portfolio.

The Fundamental Advantage strategy should not face a money market financing cost typically associated with index exposure because the financing rates on the long and short equity derivatives exposure should cancel out, providing the return of Enhanced RAFI minus the S&P 500. A diagram of how the Fundamental Advantage strategy works from an implementation perspective is shown below.

Fundamental Advantage Performance and Risk Characteristics
The two complementary return engines utilized in the Fundamental Advantage strategy not only have the potential to provide attractive, diversified investment returns, but also may deliver these returns with lower levels of volatility than is common of other investments with similar levels of return potential.

By combining two independent sources of return, Fundamental Advantage is designed to provide positive returns with limited potential for any materially negative returns over full market cycles. Importantly, the risk, or volatility, inherent in both the fixed income and equity derived alpha is not additive because the two sources of return are completely unrelated, thereby providing risk-reducing diversification.

Potential benefits of the Fundamental Advantage strategy include:

• Equity-like return potential
• Lower volatility than equities
• Low or negative correlation with the equity market

As can be expected with any strategy that assumes active risk, Fundamental Advantage strategies may deliver low or negative returns in certain environments. For example, sharply rising interest rates, a flat or inverted yield curve or sharp increases in yield spreads can affect PIMCO’s ability to add value in the Fundamental Advantage strategies. Likewise, there is a potential that Enhanced RAFI may underperform the S&P 500 over some periods of time, which would also negatively impact performance.

Equity Risk Realities
It is important to bear in mind that most traditional asset allocations are dominated by equity market risk. For instance, the equity component a portfolio with 60% of its capital in U.S. equities and 40% in U.S. bonds has historically accounted for over 90% of the volatility while the bond market contribution has averaged only 3% over the past 20 years while the residual risk is a result of a slight positive correlation between bonds and stocks over the analysis period demonstrated in the chart below. Similarly, traditional “60/40” portfolios tend to exhibit a very high (98-99%) correlation with the equity market and very little correlation with the bond market.

In light of the preexisting dominance of equity market risk in most portfolios, investors should pay particular attention to correlations with the equity market when evaluating strategies.

Equity market risk diversification is one of the key benefits that Fundamental Advantage looks to offer investors. Importantly, both the active fixed-income and the Enhanced RAFI alpha engines may deliver strong outperformance during weak equity markets, providing an offset to poor equity market returns when investors need it most. This is because Fundamental Advantage may have short exposure to overvalued stocks that can experience the greatest price declines during periods of weak equity market performance, while those same market conditions often prompt a flight to quality that can result in price appreciation in fixed income assets.

Conclusion
Fundamental Advantage is a liquid, transparent absolute return oriented strategy that seeks to capture structurally based returns from two independent sources with no material financing risk, little or no correlation with equities, and a straightforward investment process.

So while the Fundamental Advantage strategy shares a common thread with many “alternative” strategies by endeavoring to generate consistent absolute returns, maintain lower volatility than the equity market, and provide diversification benefits, Fundamental Advantage does not have many of the potential limitations or risks that may be associated with certain types of alternatives. Fundamental Advantage also may offer greater equity market risk diversification than many alternative strategies.

Whether Fundamental Advantage is considered an equity substitute, an alternative strategy or something else entirely, most investors can benefit from the potential for attractive returns with relatively modest risk and strong portfolio level diversification.