It seems paradoxical: In theory, active managers in the aggregate should not generate consistent alpha because for one investor to beat the market,
another must lag it.1,2 Yet some active managers seem to do better than others – for instance, PIMCO has consistently applied unique
insights to seek positive alpha on an after-fee basis for more than 40 years.
In this article we discuss the “structural” or “supersecular” themes that complement PIMCO’s well-known secular and cyclical investment processes. In
our opinion, the combination of structural with secular and cyclical analysis is an optimal framework for portfolio management, and it would be
extremely difficult to replicate PIMCO’s long-term success without incorporating this approach.
In the years ahead, as part of a broader global outlook we have named The New Neutral, we foresee low-single-digit returns for bonds and stocks. Thus,
we believe alpha will grow in importance to investors as they seek to achieve their goals. We suggest investors carefully consider the intellectual
framework and investment processes that a manager uses – it is clearly difficult to find the right combination.
Structural portfolio tilts or supersecular factors
PIMCO was early in identifying five factors in the fixed income markets that historically (on a supersecular basis) have offered attractive risk
premiums. Our investment process stresses the importance of constructing portfolios that have structural tilts towards these factors: duration,
yield-curve steepeners, credit spreads, volatility sales and liquidity sales. Figure 1 shows the historical returns and volatility of these factors and
below we discuss why these would be expected to generate positive returns:
- Duration: This is the basic fixed income risk factor, compensating bondholders who commit capital for an extended period of time for uncertainty
in future real interest rates and inflation.
- Yield-curve steepeners: Due to investor segmentation, the premium earned for extending maturity has been the highest between one- and two-year
tenors, and the lowest between 10- and 30-year tenors.
- Option sales: Institutional and individual investors often purchase overpriced options for hedging or speculative purposes. Selling options as a
form of “insurance” on risky assets has historically provided ample profit opportunity if scaled appropriately. This can be done either explicitly by
selling options on interest rates or implicitly by constructing “bulleted” portfolios.
- Credit/illiquidity exposure: It is a well-known fact that the spread offered on corporate issues has tended to more than compensate for
historical default rates. The owner earns a risk premium for taking default and liquidity risk. Investors are compensated because, in addition to
underperformance during economic downturns, corporate bonds may not be easy to liquidate in these circumstances. In particular, bonds rated BB have
produced the best returns, as forced selling by indexed managers often depresses prices to attractive levels. While Figure 1 does not break out the
compensation for default and liquidity risk, one measure of the liquidity premium is the incremental return of a diversified portfolio of corporate bonds
over an equivalent basket of credit default swaps. By this measure, the compensation for liquidity risk in investment grade corporate bonds has been
approximately 35 bps per year over the last decade.
Do these structural tilts still hold promise?
One of the challenges of active portfolio management is that intellectual capital over time becomes public knowledge, often even documented in the academic
literature. Yet the asset management industry often ignores these key elements of long-term alpha potential.
That said, at current valuations, we expect some of these factors to offer only a modest risk premium over the next decade. We expect structural returns
from duration in developed markets and from volatility sales are likely to be lower than in the recent past, as special factors that helped duration and
option sales – such as the long-term decline in inflation from the 1980s or large mortgage investors buying interest rate options – are no longer present.
On the other hand, we believe expected returns on credit and liquidity should be consistent with historical experience. Furthermore, identifying new,
scalable sources of structural risk premia is an integral component of PIMCO’s investment process. In our view, other factors like local currency duration
and equity beta in emerging markets (for equity-centric portfolios) are likely to offer attractive risk-adjusted returns.
Moving beyond the structural: adding the secular and the cyclical
In addition to the structural tilts that reflect our long-term (10+ years) views, the investment process at PIMCO is anchored by our annual Secular Forum
that looks out three to five years. The cornerstone of our current secular view is The New Neutral: the hypothesis that the neutral real fed funds rate is
likely to be lower than its historical average. The immediate implication is that the present value of all future cash flows and hence the price of all
financial assets must be higher than previously thought. This fundamental insight is reflected across PIMCO’s portfolios.
These long-term views are complemented by our cyclical views that look out six to 12 months and are refreshed at least three times a year through a formal
all-hands-on-deck Cyclical Forum, and fine-tuned almost daily by the Investment Committee. These discussions guide active decisions relating to the
top-down scaling of exposures to various sources of risk premia. In addition, specialist investment teams in rates, corporate credit, structured products,
real assets and equities provide inputs to our deliberations. In our view, it would be extremely difficult to outperform markets on a sustainable basis
without this combination of structural, secular and cyclical analysis (see Figure 2).
What about equities?
These structural tilts generally exhibit a low correlation with equity markets and, as such, can be an attractive overlay to equity portfolios as well. A
particularly elegant way to incorporate these tilts into the equity markets was pioneered by PIMCO in the 1980s under the name StocksPLUS. This strategy,
an implementation of portable alpha, uses derivatives to gain exposure to the equity markets, then uses the cash collateral to generate alpha potential in
the fixed income markets. In fact, last year Lipper named PIMCO the large company equity manager of the year in the U.S. for the fourth year in a row
Equity investors also could benefit from structural tilts to systematic factors that are specific to equity markets. Amongst these, the equity risk premium
is the basic factor that compensates investors for bearing uncertainty in economic growth. Option sales on equity indexes and investments in less liquid
names (small cap) tend to generate positive expected returns just as they do in fixed income. In addition, other systematic factors such as value (low
price/book) and momentum are well-known to be a historical source of incremental returns over the broad equity market. More recently, the attractiveness of
exposure to factors such as low versus high volatility and profitability (quality) also have been noted. The outperformance potential of these factors can
be partly attributed to clientele-related factors similar to those in fixed income. Some of these structural tilts are incorporated in PIMCO strategies
based on the fundamental indexes developed by Research Affiliates.
Traditionally, active equity managers have tended to focus solely on name selection. On the other hand, quantitative managers rely only on the structural
or systematic factors that have outperformed historically – often without an eye to valuations. Just as in fixed income, we believe the optimal approach to
long-term outperformance in equities combines bottom-up analysis at the security level with structural exposure to factors with attractive risk premia.
In our view, the adage that it takes active investing to keep the market broadly efficient is still true. Active asset management is critical to keeping
prices anchored to fundamentals. If the cult of passive investing were taken to the extreme, and everyone invested in capitalization- weighted indexes,
portfolios would be dominated by the entities (private or public) that issued the most equity or debt, without any sense of value.
Active management gains particular importance in this New Neutral world of muted expected returns across asset classes. Yet one is faced with the conundrum
that many active managers underperform their benchmarks after fees. Hence, finding the right active managers with the right processes is imperative. We
believe this process must include identifying structural or supersecular sources of return, along with robust macroeconomic and security-level analysis.
PIMCO has successfully incorporated this approach for more than four decades.
1Fama, E. and French, K. (2010) “Luck versus skill in the cross-section of mutual fund returns,” Journal of Finance 65 (5), 1915–1947
2Chen, Y., Ferson, W. and Peters, H. (2010) “Measuring the Timing Ability and Performance of Bond Mutual Funds,” Journal of Financial Economics 98(1), 72-89