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Economic and Market Commentary

Foxes And Hedgehogs


The fox knows many things, but the hedgehog knows one big thing.”

Isaiah Berlin  







Life, and indeed investing, can be divided into foxes and hedgehogs. No, those aren’t the latest team mascots in the NFL expansion derby. We will not have to root for the Los Angeles Hedgehogs, even though much like the Laker Girls, we may soon see a lot of LA foxes along the sidelines holding pompoms, no matter what their new name. The foxes I’m referring to are simply the foxes you’ve probably rarely seen, but have come to believe are crafty and wily and can outsmart many a hen even if well protected within the henhouse. The hedgehogs are – well – porcupines more or less. Not as interesting or as smart as the fox, that’s for sure, but they do know how to roll themselves into a ball, and that one move, at least for a hedgehog, is the difference between survival and the Big Kahuna. The two have contrasting styles, different ways of approaching life, and perhaps Isaiah (not Irving) Berlin’s famous essay said it best: "The fox knows many things, but the hedgehog knows one big thing." Life is full of foxes and hedgehogs. Take sports, for instance. Ken Griffey is a fox; Mark McGwire is a hedgehog. Michael Jordan is a fox; Shaquille O’Neal is a hedgehog. In politics, William Jefferson Clinton is a fox; Ronald Reagan was a hedgehog. You get the picture. Both animals have survived millenniums and at last report neither was on the endangered species list.

You can draw a similar parallel in the investment world. There are thousands upon thousands of investment foxes who seem, or at least pretend, to know many things: the latest whisper report on Intel’s earnings; the groups with the strongest momentum; the latest mutual fund inflows; and the up-to-date state of mind of Alan Greenspan. A few of these foxes will actually get it right and wind up bagging the hen in the henhouse, sometimes right before your very eyes. Investment hedgehogs, on the other hand, know one big thing – that markets often move like broad secular waves, which begin miles offshore. Ultimately, they crash on the beach of political, sociological, and economic change, but theirs is a longer and sometimes more predictable journey than that of the fox. If they can identify a long-term bull, bear or perhaps even a sideways market, then at least some of the darting to-and-fro that characterizes the fox can be written off as simply excess motion. No need to find the hole in the henhouse here: just identify the trend and roll into a ball. The investment hedgehog can sometimes produce a portfolio with relatively low volatility and high performance, a combination that invokes images of Merlin or David Copperfield. (Siegfried and Roy do better with tigers.) 

I mention all of this to disparage neither fox nor hedgehog – like I said, neither species is on the endangered list. PIMCO, as a matter of fact, has through the years exhibited characteristics of both. Our secular, 3-5 year forecasting approach is similar to that of the hedgehog while our quantitative analyses of bonds, as well as our use of conservative financial derivatives, have been rather fox-like. We have, in fact, been able to almost genetically meld the two over long stretches of time – witness our use of undervalued bond futures to extend the duration of our portfolios during most of the bond bull market which began back in September of 1981. By my rough calculation, nearly half of PIMCO’s long-term outperformance of the market has come from this foxy/hedgehogian idea: cheap financial futures combined with ¼ to ½ of a year of duration extension.

Now, however, with financial futures not as cheap, and the bull market in bonds probably over, the longevity of both of these critters as outperforming animals is seriously in doubt. If they are to survive (and PIMCO as well), they must adapt themselves to a changing environment as must all living things. The first order of business, then, is to correctly describe that new environment and then adapt as necessary. Actually, we’ve been describing our Brave New World for a few years now and we’ve called it Butler Creek, a world of range bound interest rates - most likely 4½% - 6½% - where yield and not price movement dominates the investment jungle. We’ve done well in this new environment with our nearly antiquated strategy because we were fortunate enough to have begun the era of Butler Creek at 6½% and to have ridden the tail end of the bull market all the way down to 4¾% with extra duration and lots of Treasury-related financial futures that did especially well during the market’s lock-up or lock-out in the fall of 1998. But with the market having backed up to 5½% and Treasuries returning to more normal yield spread relationships, there is a need for something different, for a strategic mutation that combines the same fox-like/hedgehogian characteristics we once employed, in an entirely new way.

The new idea is relatively simple - the explanation and execution a little more difficult. In simplest form what PIMCO must do is to substitute our ½ year of duration extension via financial futures - the strategy that has netted us excess returns for almost 20 years - with a similar amount of outright option sales on those same futures . Replace duration extension that provides little performance advantage in a directionless, range bound interest rate world, with option sales that generate the same amount of dollars once contributed by the previous strategy. These option sales are the perfect vehicle to take advantage of a Butler Creek world. As seen in the following chart, over the past three to four years the rolling 36-month volatility of long-term Treasury bonds has settled down to levels approaching those of the 1960s and early 70s, an era that predated the gunslinger and hedgefund traders of modern times. If volatility holds in these recent ranges and fails to spike up to levels experienced in the 1980s, then certain option strategies derived from proprietary PIMCO analytics should provide excellent returns.

Figure 1 is a line graph showing the rolling 36-month volatility of long-term U.S. Treasury bond yields, from 1962 to 1998. In early 1998, the chart shows the metric at around 0.75%, having broken out of a roughly four-year downward trending range in 1997. Yet volatility in 1998 is still relatively low: the metric was as high as about 2.3% in 1986, its peak on the chart. It also peaked around 1980 at around 2.2%. In 1962, volatility was only 0.2%.
Figure 1
Source: Bridgewater Daily Observations

I hope you’re still with me. If you’re not, let me just say this: this strategy entails no more risk than being long (or short) the market by ½ year of duration. In most cases, it is less risky. What it should do is generate up to 30 to 40 basis points of incremental return in a Butler Creek environment, and when combined with our top-notch credit analysis, singular quantitative models, and adroit sector rotation, should allow us to continue to outperform the market in a 5% interest rate environment. Without it, we will be less successful and less of the manager you have come to expect when you hired PIMCO.

Why announce this via the Investment Outlook? The early morning bugle sometimes sounds louder this way. As an investment general on the secular battlefield, I need two things: I need the PIMCO army of investment professionals to hear it, to instantaneously analyze its significance, and to embrace it in preparation for the battle. I also need support from the home front, from some of you clients whose account guidelines prevent the effective implementation of this strategy. If your account is in that category, give me, or any portfolio/account manager, a call to explain our high octane strategy in a Butler Creek world. We’ll need your understanding and your approval.

It’s not easy being both a fox and a hedgehog. Sometimes the world thinks you’re too crafty, sometimes too dull. The secret though is to be both, because the combination produces consistent long-term outperformance with market-like risk. Fox-like style. Hedgehog style. PIMCO style.

William H. Gross

Managing Director


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.

This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 

The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.

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