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.
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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).
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).
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.
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.