While equity markets have benefitted from aggressive central bank activity and signs of recovery, we believe slowing global growth and deleveraging are likely to result in lower long-term returns for most asset classes, including equities. Unresolved structural problems, particularly in developed economies, and policy uncertainty could also lead to periods of high volatility.
Equities remain an important long-term return driver for investors, but in our view, traditional approaches to building equity portfolios may not be enough. We have found three complementary ways investors can enhance their equity return potential going forward:
- Fundamental indexes in place of cap-weighted exposure
- Structurally based, alternative alpha sources
- High active share stock selection approaches
Many investors today have strong impressions of equities informed by the high-return markets of the 1980s and 1990s. A benign economic backdrop coupled with declining interest rates provided a tailwind for earnings and drove multiple expansion, resulting in annual returns in the mid- to high teens over 20 years as measured by the S&P 500. In this environment of strong capital appreciation, simply gaining exposure to equity beta, or the market’s return, was often enough for investors to achieve their return targets. This led to higher allocations to passive equity strategies and the development of the style-box framework, which, by prescribing allocations across markets caps and styles, is in effect a systematic way to gain diversified exposure to equities.
However, we believe that simply gaining exposure to equity beta is no longer enough. In this lower-return environment, alpha – return above the benchmark – and diversified sources of return are becoming more important. As a result, investors may need to rethink traditional passive and active equity solutions.
Drawbacks of traditional equity approaches
Traditional equity approaches have always presented certain drawbacks for investors, and in a lower return world, we believe these are likely to have a noticeable, adverse impact on portfolio performance.
For starters, contrary to conventional wisdom, passive index investing is not necessarily a lower-risk approach to equity ownership. For sure, passive indexing provides certain benefits, including liquidity, transparency, broad diversification and low cost. But passive index investors have full exposure to market upside and downside: By definition, passive investors will capture 100% of both an up and a down market, which has proven painful in the market declines of the past decade (Figure 1).
Looking forward, we believe alpha will be particularly valuable in helping reduce downside risk and a critical component in achieving higher long-term returns in a higher volatility environment. The negative effects of compounding magnify with volatility: If your portfolio is down 50%, you then need to be up 100% to break even. Since traditional passive approaches do nothing to cushion the downside, they may not be effective equity solutions for navigating the bumpy journey ahead.
The way traditional indexes are constructed can also be problematic. Capitalization-weighted indexes are constructed with price as a key input. It necessarily follows that overpriced stocks and sectors will be overrepresented relative to their intrinsic values and, correspondingly, underpriced stocks and sectors will be underrepresented. And the more distorted the prices of a particular sector or stock become, the greater the ultimate cost to investors should the market correct. Consider the following passive equity investor’s experience over the past 25 years (Figure 2).
After experiencing a bubble in Japanese equities in their global or international equity allocations in the late 1980s, investors were hit by the technology bubble in the early 2000s and then the bubble in financials leading up to the credit crisis. Each of these bubbles burst, with cap-weighted indexes participating fully in these painful corrections.
While these drawbacks call traditional passive approaches into question, going active also has its challenges. It has long been difficult to identify managers who can consistently deliver meaningful outperformance after fees across different market cycles, especially in the most efficient segments of the market like U.S. large cap equities. But now, this challenge is exacerbated by a noteworthy shift among active managers to become more benchmark-like over time.
Thirty years ago, virtually all equity managers were active or highly active as measured by active share. However, as the focus on benchmarking and tracking error took hold, this changed. Today, traditional active equity approaches, on average, involve significantly lower levels of active risk (Figure 3), making it even more difficult for investors to select managers with the potential to deliver meaningful alpha after fees over the long term.
Given these challenges, we believe investors would benefit by moving away from traditional equity approaches and considering three options that can potentially lead to higher returns.
Option #1: Use fundamental indexing
The problem with traditional indexes is that they use only one input in the index construction process – market capitalization – and this input is a function of price. Fundamental indexes instead select and weight stocks based on a variety of non-price measures of company size. By using multiple inputs, rather than one, and by removing price from the construction process, fundamental indexes can avoid the distortions observed in cap-weighted indexes and the associated performance drag.
Importantly, using the Research Affiliates Fundamental Indexes (RAFI) as an example (Figure 4), fundamental indexing may provide investors with a valuable source of additional returns.
Option #2: Take advantage of structurally based, independent sources of alpha
Consistent with the idea of alternative approaches to index construction, our second option is an “index-plus” approach that couples equity market exposure with an independent, alternative, structurally based alpha source. In this approach, equity index exposure is obtained synthetically (using futures and swaps) with a focus on minimizing the rate paid for short-term money market financing. The futures and swaps are collateralized by a high-quality, liquid, actively managed portfolio, typically an absolute-return-oriented bond portfolio designed to outperform the short-term rate. If this fixed income portfolio outperforms money market rates and manager fees, then the investor receives the equity market return “plus” this incremental return (Figure 5).
Index-plus strategies offer equity investors a unique opportunity to seek structurally based excess returns by capitalizing on a longer time horizon than that of a money market investor. Because the beta comes from exposure to an equity index and the alpha from exposure to an actively managed fixed income portfolio, they also offer investors the ability to obtain valuable diversification within the strategy itself (between the alpha and the beta) and within a broader equity allocation when combined with stock-selection-based strategies. Index-plus strategies are available for a range of cap-weighted and fundamental index exposures globally, and we believe these approaches offer a prudent way to potentially enhance equity returns.
Option #3: Emphasize active share with stock selection approaches
Our third approach relates to stock-selection-based active equity strategies: Investors should choose truly active managers, as defined by active share − the percentage of a portfolio that is different from its benchmark. Active share is an objective, holdings-based metric that effectively reveals a manager’s active risk.
Figure 6 shows that in the global equity fund universe, less than 25% of “closet indexers” (managers with less than 60% active share) outperformed their benchmarks and on average underperformed over the five-year period. For managers with active share between 60% and 90%, less than 45% outperformed, though as a group they did outperform. For managers with active share greater than 90%, more than 60% outperformed and delivered average annual outperformance of 3.6%. While different studies and time periods may produce different results, this study offers compelling data to consider the merits of high active share equity management.
There are a couple of key takeaways here. First, be wary the closet indexer, as you will likely be better off going passive than paying fees for a benchmark-like strategy. And second, to improve equity return potential, use active share in manager selection. We suggest performing deep due diligence on managers, evaluating their people, their philosophy, their process and their resources. And if you conclude the manager’s research is high quality, then ensure they run high active share portfolios. We believe this combination of research quality and high active share can result in meaningful alpha opportunity over the long term.
Bringing it all together
At PIMCO, we’ve built equity capabilities consistent with these investment approaches. We have not created traditional benchmark- and style-box-oriented active equity strategies; instead, we offer index-plus, fundamental index-plus and high active share stock-selection-based active equity strategies. We believe these complementary equity strategies are well-positioned to provide the alpha opportunity needed by investors in this more challenging environment.