September 30th marked the third anniversary of the launch of PIMCO’s innovative International Fundamental IndexPLUS AR and Small Company Fundamental IndexPLUS AR strategies. Designed to deliver two sources of excess return potential to investors in addition to the return of the equity market, the strategies are extensions of the U.S.-based Fundamental IndexPLUS AR strategy launched in 2005. They are also part of PIMCO’s broader suite of Fundamental Index StocksPLUS strategies, which also include emerging market equity, global equity and equity market neutral strategies.
In this Q&A, Rob Arnott, Founder and Chairman of Research Affiliates, and Sabrina Callin, PIMCO managing director and product manager, discuss this innovative Fundamental Index-based equity approach, and how these unique equity strategies combine the strengths of PIMCO and Research Affiliates to provide a powerful path forward for equity investors.
Q: How does the collaboration between Research Affiliates and PIMCO contribute to the success of the Fundamental Index StocksPLUS suite of strategies?
Arnott: PIMCO was one of the very first affiliates to launch products based on the Fundamental Index concept – well before “Smart Beta” was all the rage. When we launched the Fundamental IndexPLUS AR strategy in June 2005, we envisioned a suite of products that would draw on the collective strengths of PIMCO and Research Affiliates, including both firms’ insights, process and people. We believed then and we believe now that this combination will deliver materially superior results to our investors.
Our team at Research Affiliates manages the Enhanced RAFI (Research Affiliates Fundamental Index) equity strategy, which is offered exclusively in partnership with PIMCO. Our research suggests that a process that selects and weights stocks based on underlying company economic fundamentals instead of market capitalization produces powerful results in historical testing, well above cap-weighted benchmarks, all over the world, including U.S. large cap, small company, international, global and emerging market equities.
PIMCO’s team manages the absolute return bond strategy, which adds a complementary source of alpha and diversification potential to the Fundamental IndexPLUS AR strategies. PIMCO has almost 30 years of experience in adding bond market alpha onto stock market returns. If PIMCO can beat the money market rate – which drives the pricing of the equity-linked instruments used to gain access to the Enhanced RAFI portfolios – then there are multiple complementary and uncorrelated alphas.
Q: Can you provide more detail on the advantages of Enhanced RAFI and how it is managed?
Arnott: Research Affiliates is responsible for the excess returns of Enhanced RAFI relative to the corresponding cap-weighted equity index benchmark. The largest excess return driver is the rebalancing aspect to the strategy. Companies whose prices appreciate more than the fundamental scope of the business (as measured by sales, cash flow, book value and dividends) get trimmed. Conversely, we boost exposure to securities that fall in price more than business fundamentals. In short, we sell recent winners and buy recent losers.
Our long-term research suggests that this contra-trading, against the market’s most extravagant recent “bets,” is worth roughly 2% in excess returns, across various markets around the world, with low turnover and economically representative exposure. So the people on the opposite side of these contrarian trades – the legions who buy recent winners and sell recent losers – in theory “pay” us 2% excess returns. For example the Enhanced RAFI US Large Index returned 3.51% annualized vs. the S&P 500 during our sample period from 12/31/1962 to 10/31/2014. We all know people who behave this way. They’re the return chasers who have been identified in studies like Russ Kinnel’s “Mind the Gap,” and some of our own work (see “Slugging it out in the Equity Arena,” by John West and Ryan Larson at Research Affiliates).
We believe these excess returns are structural and persistent – not in every quarter or every year, of course, but over the long term. Furthermore, with Enhanced RAFI we add additional screens to the stock selection process. For example, we emphasize companies with high quality earnings and de-emphasize or eliminate companies that show potential signs of distress. We also adjust our stock positions in an effort to achieve better diversification of our active “bets,” with less dramatic bets (over- or underweight) among the large companies and slightly more aggressive bets (again, over- or underweight) among the smaller companies. Finally, we use a rebalancing mechanism that allows momentum to run its course, rather than contra-trading against market momentum too hastily.
Q: What value does PIMCO bring to these unique equity strategies?
Callin: The PIMCO Enhanced RAFI-based StocksPLUS strategies combine the best of what passive indexing and active management aim to deliver: broadly representative, transparent equity exposure plus the potential for meaningful equity market outperformance. Rather than buying physical stocks, we use equity-linked instruments, which tend to provide approximately the same returns as owning the underlying stocks, to gain Enhanced RAFI exposure in exchange for paying a money-market-based interest rate. The key benefit is that we do not have to pay cash for the equity exposure up front. Because the equity ownership can be obtained at a money-market-based cost, it allows equity investors to potentially use their money more efficiently and to capitalize on their longer-term time horizon to a much greater degree. If the cash was then invested at a money market rate, for example, the total return to the investors would be approximately the same as the return of the equity index. We believe a better approach is to invest that cash in a high quality, absolute return bond alpha strategy – the “PLUS” component – which is designed to outperform the money-market-based financing rate, thereby delivering returns above those provided by the equity strategy.
Basically, if you believe PIMCO can outperform a money market rate, then that translates into a belief that the PIMCO active management component should deliver additional value to equity investors.
One of the reasons many investors find Fundamental Index StocksPLUS strategies so compelling is that they deliver two independent sources of potential equity market outperformance for every unit of capital invested in the strategy – the return of the absolute return bond alpha strategy above that of the money market cost, plus the returns of the Enhanced RAFI equity strategy over a market-capitalization-weighted equity index. In addition, each potential source of return is likely to have a relatively low correlation with one another, offering potentially meaningful diversification benefits.
Q: Can you discuss the backgrounds of the portfolio management team?
Callin: The highly qualified management team has more than 100 years of collective investment experience across all major global asset classes. In addition to Rob and his expert team at Research Affiliates, the PIMCO portfolio management team includes managing directors Mohsen Fahmi and Sudi Mariappa. By extension, Mohit Mittal and Dan Ivascyn, PIMCO’s Group Chief Investment Officer, who are members of the broader Unconstrained Bond portfolio management team, are also active contributors. Importantly, while each portfolio management team member individually contributes significant expertise and unique perspectives, they also draw on the collective depth and breadth of the entire PIMCO team in managing the absolute return bond alpha strategy component of these strategies, and specifically on our equity trading specialists in maintaining the Enhanced RAFI exposure using index-linked instruments.
The team approach has long served as a hallmark of the PIMCO investment process. And it is with this framework, team and process that we look forward to continuing to pursue attractive returns for equity investors in the year ahead.
Q: Many investors don’t associate PIMCO with equities, yet PIMCO won the Lipper Equity Manager of the Year award in 2010, 2011, 2012 and 2013 in the U.S. Is this an anomaly?
Callin: I believe it is unprecedented for one company to win the Lipper Equity Manager of the Year award four times in a row, but remember, unlike many other equity strategies, our approach captures two independent sources of structurally based value add for investors, building on the long-established team approach that combines the strengths and insights of both Research Affiliates and PIMCO. Taken together, we believe these teams and strategies are poised to deliver very attractive results to equity investors prospectively. And now, perhaps more than ever, equity strategies that deliver meaningful excess returns – in addition to the return of the equity market – may be key to allowing investors to meet their return targets going forward.