Strategy Spotlight

An Innovative Approach to Enhancing Small Cap Allocations

Index returns and traditional active management may fall short, so PIMCO StocksPLUS Small takes a different path to seek small cap alpha.

The broad underperformance of active equity managers versus their benchmarks over the past decade is widely known,1 and many observers argue that the best alpha opportunities are in less-efficient market segments, such as small cap stocks. Yet selecting a high-performing small cap manager may also prove challenging, for a number of reasons. Here we look at why investors may want to look beyond traditional small cap strategies – and how PIMCO StocksPLUS Small Fund has been beating its benchmark for over 10 years.

Figure 1 is a table showing performance before and after fees of the StocksPLUS Small Fund for one year, three years, five years, 10 years, and since inception in 2006. The returns are compared with those of the Russell 2000 Index. Data as of 30 September is detailed within.

For the most recent quarter-end performance data for the PIMCO StocksPLUS Small Fund, please click on the link below:

Indexing and traditional active management may both fall short

Passive investing has served equity investors well over the past decade, allowing them to pay reduced fees while enjoying attractive returns since the markets troughed in 2009. But given current stretched valuations and an aging bull market, these levels of returns seem unlikely to continue. Investors who rely on beta alone may struggle to meet their return targets. We believe alpha will be critical – but can investors rely on traditional active managers to deliver the excess returns they are seeking?

Despite the perception that small cap equities are fertile ground for stock picking, managers’ results have been sobering: 85% of small cap managers lagged their passive peers over the last five years (ended 30 June 2018), and 82% underperformed over the last 10 years, according to Morningstar. Moreover, the top-performing small cap managers often become victims of their own success. Some have closed their funds to new investors after reaching a certain size – good for the strategy, but disappointing for investors who get shut out. Others may continue to accept new assets but then compromise their investment strategies to accommodate the larger asset base, either by moving up the market cap spectrum or becoming more diversified. In either case, the manager may fail to provide investors the small cap exposure they sought.

Given these challenges and an environment of lower expected returns, we believe investors may need to consider alternative approaches to enhance their small cap allocations. PIMCO StocksPLUS Small Strategy offers an innovative solution that goes beyond the equity space in pursuit of reliable alpha, with relative freedom from capacity constraints.

A differentiated approach to seek more consistent alpha

At PIMCO, we bring a different perspective to equities. Unlike traditional active equity managers that attempt to outperform benchmarks by picking stocks, PIMCO StocksPLUS Small pursues excess returns from the global bond market – a larger opportunity set that has historically offered more reliable excess return potential. Although this approach to generating alpha may be nontraditional, our time-tested methodology is straightforward and offers the potential for more consistent excess returns.

Here is how it works. The strategy gains passive exposure to the Russell 2000 Index using futures or total return swaps. By investing in equity index futures or swaps, investors receive the total return of an index less a short-term financing cost (typically very close to three-month Libor). This method of gaining equity index exposure requires only a small upfront payment, freeing up roughly 95% (or more) of invested capital to pursue excess returns through a high quality bond alpha strategy. In essence, if the returns of the bond alpha strategy exceed the cost of gaining exposure to the Russell 2000 Index, the strategy will outperform (see Figure 2).

Figure 2 uses a series of bars to illustrate the equation of beta plus alpha to equal the total return of the PIMCO StocksPLUS Small Fund as of September 2018. Beta is represented by a bar on the left, totaling 8.04%. Alpha comprises two bars, one of negative 0.71% in equity financing cost, and a bar showing the bond alpha portfolio return of 5.25%. The total return, shown in a bar on the right, includes the 8.04% beta and the cumulative 4.55% of alpha.

Capitalizing on inefficiencies in the small cap market

There are various ways to gain passive exposure to the Russell 2000 Index, including index funds, exchange-traded funds (ETFs), futures and swaps. While each vehicle offers potential advantages, structural inefficiencies in the small cap market make investing in Russell 2000 Index futures and swap contracts particularly compelling.

Why? Let’s say an investor wants to short a small cap stock. The investor would need to find an available block of shares to borrow, sell and then buy back, at (hopefully) a lower price. Finding shares to borrow can be difficult in the less-liquid small cap market, which drives up the cost of borrowing those shares. High borrowing costs at the stock level translate into high shorting costs at the index level. In other words, investors who short-sell the Russell 2000 futures pay a premium, given the difficulty of shorting small cap stocks. For the investor who wants long exposure to the Russell 2000 Index, this dynamic becomes a benefit in the form of discounted financing for futures and swaps. 

Given that small cap stocks may be more difficult and costly to borrow, some investors simply prefer the ease of using Russell 2000 futures to obtain short exposure. This potential incremental demand for shorting Russell 2000 futures also drives down the cost of gaining long exposure. The potentially less-liquid nature of small cap stocks has resulted in persistently cheap (generally below-Libor) financing costs that are not typical for other futures contracts, such as those on the S&P 500 (see Figure 3).

Figure 3 is a bar graph showing the futures financing costs annualized spread relative to Libor per quarter expiration, from 2003 to mid-year 2018. For the Russell 2000, spreads are in the negative for most quarters, represented by bars dropping down from a horizonal zero line. The graph shows the cost reaching as low as minus 240 basis points in 2008, and averaging negative 76 basis points over the period. Spreads for the S&P 500 were generally either negligible or as much as a positive 50 basis points or more, with an average of 10 basis points over the period.

Flexibility to tap the most attractive financing

Although the “cheapness” of funding Russell 2000 futures has tended to persist, the cost of financing can vary with shifts in supply and demand. As Figure 3 shows, in the fourth quarter of 2017 and early 2018, Russell 2000 futures costs were at a premium to Libor for the first time in the approximately 15 years that we have been tracking roll costs for the contract. PIMCO’s equity traders anticipated the sharp increases in futures roll costs and took advantage of more attractive financing opportunities in the swap market. Cheap financing costs are not guaranteed, and investors who are dependent on futures would have little choice but to pay these elevated costs. We believe PIMCO’s presence and capabilities in global markets give us a distinct competitive advantage when it comes to finding the most attractive financing opportunities for our investors.

A time-tested way to seek consistent alpha

In the environment ahead, investors will likely need significant alpha to meet their investment goals. And given the challenges of capturing equity alpha – even in small cap stocks – investors may need to consider alternative approaches.

For investors seeking an allocation to small cap stocks, we believe PIMCO’s StocksPLUS Small strategy is a compelling solution, offering access to a historically more reliable source of alpha (see Figure 4) and at a lower cost. We expect Russell 2000 Index futures to provide attractive funding levels in most market environments, offering an additional potential source of structural alpha.  And because this market is large and liquid, as are the fixed income markets in which we typically invest, we do not anticipate capacity constraints.

Figure 4 is a scatter plot of rolling monthly five-year returns for PIMCO StocksPLUS Small Fund, shown on the Y-axis, versus Russell 2000 Index, shown on the X-axis, for the time period March 2006 through 30 September 2018. All of the plots are in positive territory, and most of them are above a diagonal line that marks where the returns for both StockPLUS and the benchmark are equal. This indicates that for most months, the five-year rolling return for StocksPLUS Small Fund generates alpha above the Russell 2000 Index.

While the StocksPLUS approach may be nontraditional, it is not untested: We have been managing these portfolios for more than three decades, providing access to various equity market segments and historically delivering meaningful and consistent outperformance across a variety of market environments.   

To learn more about putting StocksPLUS Small to work for you, visit our fund page: StocksPLUS Small Fund.

1According to S&P Dow Jones Indices’ midyear 2018 SPIVA U.S. Scorecard.
The Author

Laura Graff

Product Strategist

View Profile

Latest Insights


Related Funds


Investors should consider the investment objectives, risks, charges and expenses of the fund carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative or by visiting Please read them carefully before you invest or send money.

Past performance is not a guarantee or a reliable indicator of future results. The performance figures presented reflect the total return performance for Institutional Class shares (after fees) and reflect changes in share price and reinvestment of dividend and capital gain distributions. All periods longer than one year are annualized. The minimum initial investment for Institutional class shares is $1 million; however, it may be modified for certain financial intermediaries who submit trades on behalf of eligible investors.

Investments made by a Fund and the results achieved by a Fund are not expected to be the same as those made by any other PIMCO-advised Fund, including those with a similar name, investment objective or policies.  A new or smaller Fund’s performance may not represent how the Fund is expected to or may perform in the long-term.  New Funds have limited operating histories for investors to evaluate and new and smaller Funds may not attract sufficient assets to achieve investment and trading efficiencies.  A Fund may be forced to sell a comparatively large portion of its portfolio to meet significant shareholder redemptions for cash, or hold a comparatively large portion of its portfolio in cash due to significant share purchases for cash, in each case when the Fund otherwise would not seek to do so, which may adversely affect performance.

Differences in the Fund’s performance versus the index and related attribution information with respect to particular categories of securities or individual positions may be attributable, in part, to differences in the pricing methodologies used by the Fund and the index.

There is no assurance that any fund, including any fund that has experienced high or unusual performance for one or more periods, will experience similar levels of performance in the future. High performance is defined as a significant increase in either 1) a fund’s total return in excess of that of the fund’s benchmark between reporting periods or 2) a fund’s total return in excess of the fund’s historical returns between reporting periods. Unusual performance is defined as a significant change in a fund’s performance as compared to one or more previous reporting periods.

A word about risk:

In managing the strategy’s investments in Fixed Income Instruments, PIMCO utilizes an absolute return approach; the absolute return approach does not apply to the equity index replicating component of the strategy. Absolute return portfolios may not fully participate in strong positive market rallies. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. 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. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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.  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. Diversification does not ensure against loss. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. It is not possible to invest directly in an unmanaged index. 

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Long: buying an asset/security that gives partial ownership to the buyer of the position. Long positions profit from an increase in price. Short: selling an asset/security that may have been borrowed from a third party with the intention of buying back at a later date. Short positions profit from a decline in price. If a short position increases in price, the potential loss on an uncovered short is unlimited.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. 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 investment professional prior to making an investment decision.

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. 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 is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.

Investment Products

Not FDIC Insured | May Lose Value | Not Bank Guaranteed


XDismiss Next Article