PIMCO and Research Affiliates recently expanded their suite of smart beta-based equity strategies, opening a new chapter in a collaboration that for more than 10 years has delivered a host of successful and innovative solutions to investors. In the following interview, Sabrina Callin, PIMCO managing director and product manager, and John West, Research Affiliates managing director and head of client strategies, explain how the new strategies are designed to advance the smart beta concept by combining attributes of both traditional indexing and active management.
Q: There’s been a lot of talk lately about smart beta strategies but less agreement on what they are. How do PIMCO and Research Affiliates, both early adopters in the space, think about smart beta?
Callin: Although neither firm coined the term, Research Affiliates is broadly credited with pioneering the concept that later came to be known as smart beta with its groundbreaking work on Fundamental Indexation (“Fundamental Indexation,” Arnott, Hsu and Moore, Financial Analysts Journal, March/April 2005), and Research Affiliates and PIMCO were the first to launch a fundamental index-based equity strategy. Over the years we have continued to refine our approach and expand our range of smart beta-based enhanced equity strategies, including with the launch of the new PIMCO RAE (Research Affiliates Equity) Fundamental offerings.
We believe smart beta is an important evolution in our industry. This rapidly growing category provides investors with a potentially valuable third option beyond traditional passive approaches designed to replicate market-cap-weighted indexes and typical active approaches where portfolio managers select securities based on company research.
West: While a number of different names and definitions have been put forth, the category is generally understood to represent systematic, rules-based approaches that are designed to seek better risk-adjusted, long-term returns than those of a corresponding market portfolio. The commonality across smart beta strategies is a portfolio construction process that breaks the link between the price of an asset and its weight in a portfolio. In breaking this link, smart beta strategies seek to avoid the performance drag inherent in capitalization-weighted market indexes that necessarily overweight overpriced stocks and underweight underpriced stocks.
Importantly, many smart beta-based strategies have established long-term successful track records. In fact, as of June 30th two of the PIMCO RAE Fundamental strategies will have live track records that extend back a full decade – what has, in my mind, been a full market cycle.
Q: Why are investors increasingly attracted to non-traditional approaches to obtaining broad equity exposure like RAE Fundamental?
Callin: In a New Neutral world of lower prospective stock and bond market returns, many investors recognize that they need to do something differently in order to achieve their return objectives. With equities, which often represent the dominant asset class exposure in an investment portfolio, an approach that provides meaningful extra return on top of the market can make a big difference over the long term.
By definition, passively managed market-capitalization-weighted equity index strategies can provide only the market return less fees and transaction costs. And some investors have been disappointed by the performance results of active managers who rely on bottom-up stock selection to outperform the market. Smart beta approaches, and by extension PIMCO’s RAE Fundamental strategies, provide investors with an additional option for obtaining equity exposure that
we believe provides a nice complement to more traditional approaches.
Based on a fundamentally weighted approach, PIMCO’s RAE Fundamental strategies avoid the market-cap “trap” and incorporate active insights systematically to refine portfolio weightings. They also seek to deliver attractive performance while maintaining broadly diversified, economically representative equity exposure.
Q: Can you elaborate on how the PIMCO Research Affiliates Equity suite employs a smart-beta approach and builds on it?
West: Like the Research Affiliates RAFI Fundamental Index portfolio construction process, the PIMCO RAE Fundamental strategies start with the selection and weighting of securities based on non-price measures including sales, cash flow, dividends and book value. This effectively captures a firm’s “economic footprint” without linking portfolio weight to security price. The portfolio is then refined by active yet systematic portfolio construction techniques designed to further enhance returns.
The systematically implemented insights are designed to emphasize financial health, take into account momentum and redistribute the portfolio’s active weights (i.e., the resulting bets against the market) to areas identified by Research Affiliates as likely to be more profitable. The overall result is an efficient enhanced equity approach that embraces the principle of buying low and selling high. Research robustly suggests that such an approach supports attractive structurally-based outperformance over time. But, critically, this approach is designed to help ensure sufficient capacity with the aim of achieving relatively low portfolio turnover and transaction costs.
Q: How do the actively identified insights work to advance the smart beta concept?
West: RAE Fundamental Strategies employ insights in areas where our research identifies robust opportunities to increase expected returns – without increasing volatility – that we believe are best implemented outside of an index construct. Importantly, while the insights evolve over time, we do not implement new refinements without subjecting the findings to a rigorous review process.
For example, we reduce or eliminate weights to companies that may be “cheap” because they appear to be under distress. Likewise, we boost exposure to companies that appear to be particularly healthy. In addition, our research suggests that it is best to avoid trading against short-term momentum. As a result, our rebalancing process adjusts for recent price momentum to avoid catching the proverbial “falling knife.” We also proactively seek to add diversity benefits to our active weights: Shifting weights from relatively expensive value companies to cheaper growth companies to emphasize stocks with the greatest potential for appreciation is a way to diversify by style; diversifying positions by company size avoids concentrations in over- or underweight positions in larger companies and shifts that exposure to smaller firms where the probability of mispricing is greater.
The final weight of each company is based on the combination of fundamental measurements and systematically implemented insights designed to create a broadly representative and diversified portfolio with the goal of consistently delivering meaningful equity market outperformance over time.
Q: What is the scope of the PIMCO RAE product suite?
Callin: Together, PIMCO and Research Affiliates developed and launched our first smart beta-based RAE Fundamental PLUS strategy 10 years ago, long before the term ”smart beta” came into existence.
Since that time we have evolved our RAE PLUS offerings to include not only additional equity market segments like emerging markets, small company, international and global developed, but also market neutral strategies, low volatility strategies and the Worldwide Long/Short strategy we launched last December. The RAE PLUS equity strategies combine the different types of RAE fundamental equity exposure with PIMCO’s well-established StocksPLUS methodology, which seeks to further enhance equity returns and diversify risk by complementing equity exposure with an absolute return bond alpha strategy. The result is a powerful combination that draws on both firms’ core competencies and expertise, with the goal of consistently delivering meaningful equity market outperformance to long-term investors.
The latest additions to the PIMCO RAE platform include RAE Fundamental strategies that invest directly in stocks and are available across a range of equity exposures including Europe, U.S. , global developed and emerging markets. We are excited to be expanding our longstanding and successful relationship with Research Affiliates and the depth and breadth of our equity solutions.