Efficient capital deployment may prove crucial to plan sponsors seeking to meet specific return targets amid low prospective returns across many asset classes. Since its launch 10 years ago, PIMCO StocksPLUS Long Duration Fund has championed a capital-efficient strategy that combines returns from equities and long-term bonds. As discussed by portfolio managers Mohit Mittal and Mike Cudzil and product strategist Vijendra Nambiar, we believe the Fund is well-positioned to make every invested dollar work harder in an effort to help investors achieve their objectives.

Q: How does PIMCO StocksPLUS Long Duration Fund make every dollar work harder?

A: The strategy is premised on the reality that most investors will own a certain amount of equities and bonds. It obtains S&P 500 equity exposure passively, via futures or swaps. Then – because synthetic equity exposure typically requires only a modest initial cash outlay – capital is freed-up and invested in actively managed long-term bonds benchmarked to the Bloomberg Barclays Long Government/Credit Index. Ultimately, the Fund should achieve a return commensurate with that of passive equities plus actively managed long-term bonds, less the financing rate embedded in the equity derivatives contracts.

Q: How has the Fund performed?

A: While the S&P 500 Index provided 7.4% annualized returns over the 10 years ended 30 September 2017, PIMCO StocksPLUS Long Duration Fund returned 14.4% (after fees), outperforming equities by roughly 700 basis points (bps) (see Figure 1).

For the most recent quarter-end performance data for the StocksPlus Long Duration fund, please click on the link below:

Q: How can an allocation to StocksPLUS Long Duration Fund make portfolios capital efficient?

A: The strategy can free up dollars to invest in other asset classes or investment opportunities to enhance return potential. Consider Figure 2, which shows returns and risk over the last 10 years for two hypothetical portfolios.

Based on historical data, both portfolios offered similar risk and returns. This suggests an investor could have achieved a risk/return profile commensurate with the 60/40 portfolio with only 45% of the capital. The remaining 55% of capital could have been used in other investments to potentially enhance overall returns.

This would be especially valuable in a low-return environment.

Q: Several potential combinations of asset classes could be implemented. Why choose to pair long-term bonds and equities?

A: This question gets to a key point. Dual exposure on invested capital involves a degree of leverage. Therefore, it is imperative to consider the risk and correlations in the combined exposures.

Pairing long-term bonds and equities has several potential advantages:

Long-term bonds historically have had low to negative correlations with equities. Therefore, they may offer meaningful diversification potential when equity markets are weak. By reducing drawdowns in challenging periods (as the performance of long bonds could offset equity market weakness), investors may benefit more significantly if and when markets eventually rebound (see Figure 3).

Long bonds have historically outperformed the equity-overlay financing rate (which is typically close to three-month Libor). As yield curves normally exhibit some level of steepness, a long-term bond portfolio has the potential to generate an attractive yield premium relative to the equity-overlay financing rate, which is based on very short-term interest rates such as Libor (see figure 4).

Active management of the long bond portfolio provides an additional source of excess return potential. PIMCO’s bottom-up and top-down investment process has helped to deliver alpha potential in long bond portfolios over most full market cycles.

With our sizeable and skilled resources, we believe PIMCO is in a position to extract potential premiums that may elude competitors.

Q: Wouldn’t StocksPLUS Long Duration underperform in a rising rate environment given the interest rate sensitivity of long-term bonds?

A: While the long bond collateral portfolio could be negatively affected by rising rates in the short run, over the medium to long term we expect long duration bonds will achieve a return consistent with their yield at the time of purchase (absent defaults) – and therefore should enhance the return profile of an overall portfolio.

To be sure, historical performance shows that over shorter periods, the combined equity and long bond strategy has sometimes underperformed equities when rates rise.

However, over longer horizons – typically three- and five-year rolling periods – the combined strategy has outperformed equities a large majority of the time (see Figure 5). In fact, over the last 20 years, a period that included both rising and falling interest rate environments, the combined equity and long bonds portfolio would have outperformed equities in the vast majority of three- and five-year rolling periods.

Furthermore, we believe the following key attributes can help the strategy in a rising rate environment:

  • The long bond collateral portfolio is diversified across government and corporate securities. In rising rate environments, corporate spreads tend to tighten, helping offset the impact of rising rates.
  • The long bond portfolio is actively managed. This is critical to capturing highly intermingled structural sources of return. We engage actively in sector rotation, security selection, duration, yield curve positioning and other strategies, with a significant emphasis on diversification that is designed to mitigate downside risk. Top-down and bottom-up considerations inform portfolio construction, helping us navigate challenging environments, such as rising rates. Our success in managing long duration bond portfolios since 1988 (a period that included rising and falling interest rate environments) speaks to the strength of our disciplined investment process and portfolio construction approach.

Q: How does PIMCO’s experience and investment management philosophy add value to the StocksPLUS Long Duration Fund?

A: The Fund had its 10-year anniversary last August and over the years we’ve learned that the management of synthetic equity portfolios with long duration bonds is an intricate process. The use of derivatives introduces collateral-management requirements, and frequent rebalancing of the equity overlay and the underlying collateral portfolio exposures can prove quite cumbersome.

Our tightly integrated portfolio management, risk management and equity trading operations facilitate effective liquidity and collateral management. PIMCO has navigated the management of these types of portfolios in several difficult market environments (including the 1987 stock market crash and the late 2008 global financial crisis). Holistic risk management is essential for optimal implementation. 

PIMCO has more than three decades of experience in managing two independent return sources (equities and bonds) in one bundled portfolio. This know-how  gives investors the potential to benefit from the combination and improve the capital efficiency of their portfolios, while leaving the operational nuts and bolts to PIMCO. 

Q: Any final thoughts on the StocksPLUS Long Duration Fund?

A: We launched the StocksPLUS Long Duration Fund in 2007 in response to client and consultant demand for an equity solution that seeks to provide liability-hedging benefits (via the long bond portfolio). However, the application of this strategy has broadened beyond liability-hedging for private sector DB plans. Asset-only investors are also increasingly considering it as a means to enhance return potential.

Over the last 10 years, investors have harnessed what we consider to be the capital efficiency of this strategy as an additional element in their portfolio construction tool kit to seek increased long-term returns with lower incremental risk. The strategy has become ever more relevant across the spectrum of investors, including public pension plans, foundations and endowments, and individuals in tax-deferred accounts.

In the context of future low expected returns, we believe it is vital to have a capital-efficient strategy to seek improved potential for meeting or exceeding future obligations. The stark risk of lower expected returns not only hurts institutional investors such as pensions and insurance companies, but also has a meaningful impact on individuals and households saving for retirement. Indeed, a recent study by the McKinsey Global Institute shows that a reduction of two percentage points in annual returns over an individual’s retirement savings horizon, a 30-year-old would have to work seven years longer or double their savings rate to remain on an equal footing (see Figure 6).

Even a small decrease in future returns can have a major impact on retirement savings. Lower returns translate into potentially lower living standards at retirement or the need to save more (which may also be challenging in a low wage-growth environment).

By harnessing the capital-efficiency characteristics of StocksPLUS Long Duration, however, investors can seek higher returns with lower incremental risk and potentially alleviate the issues associated with not saving enough for retirement.

The Author

Mohit Mittal

Portfolio Manager, Liability Driven Investment and Credit

Mike Cudzil

Portfolio Manager, Liability-Driven Investment

Vijendra Nambiar

Product Strategist, Pension and Investment Solutions

Related

Related Funds

Disclosures

Investors should consider the investment objectives, risks, charges and expenses of the funds 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 PIMCO representative. Please read them carefully before you invest or send money.

Past performance is not a guarantee or a reliable indicator of future results.

A word about risk:  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. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. 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. 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. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. 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 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. 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. 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.

No assurance is being made that any fund that may have experienced high or unusual performance for one or more periods will continue to experience such performance. High performance is defined as an unusual growth in alpha between reporting periods or total return when measured to historical returns. Unusual performance is defined as an unusual change in performance (+/-) between reporting periods and the portfolio experienced unusual performance for one or more periods. Note: Equity exposure in PIMCO StocksPLUS Long Duration Fund is based on S&P 500 Index exposure.

Hypothetical examples are for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. Bloomberg Barclays Long Term Government/Credit Index is an unmanaged index of U.S. Government or Investment Grade Credit Securities having a maturity of 10 years or more. It is not possible to invest directly in an unmanaged index. The 3-Month LIBOR (London Interbank Offered Rate) Index is an average interest rate, determined by the ICE Benchmark Administration, that banks charge one another for the use of short-term money (3 months) in England’s Eurodollar market.

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. ©2017, PIMCO.

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

CMR2017-1110-300668

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