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.