PIMCO's product addresses a significant issue: If you believe indexed, passive management is the best or primary way to go, are you then limited to the returns inherent in that index? Or can you manage to do better, and if so, how much better? PIMCO's answer is you can do better, and the authors outline a way to do it.
What is an enhanced equity index strategy and how does it differ from both indexing and traditional active equity management techniques?
Typically, when someone refers to equity 'indexing,' they are referring to a passive strategy that is designed to match the returns of the underlying index with a very low tracking error -or standard deviation of monthly excess returns (positive or negative) - to the index. Alternatively, 'active' equity management generally includes strategies that are designed to provide significant returns in excess of the benchmark using any number of different investment strategies. Notably, while passive indexers have generally delivered index-like returns, most active equity managers have had a very difficult time beating their benchmark, let alone beating that benchmark consistently. This has been especially true with respect to the S&P500 Index in recent years. Of course that does not mean that active managers have provided reduced risk versus the underlying index. Unfortunately, all too often investors in these active equity management strategies have had to endure volatile returns, a large tracking error to the benchmark, and underperformance at the same time.
So does this mean that the clear best choice is to index, eliminating potential excess returns all together? Fortunately it does not. Rather, there is an alternative, generally referred to as 'enhanced indexing,' that is becoming increasingly popular with institutional investors. As the name implies, enhanced indexing strategies are designed to provide the returns of a given market index. However - unlike passive indexing strategies - enhanced indexing strategies also aim to provide moderate returns in excess of the index. Importantly, though, these strategies are designed to be consistent with low tracking error to the underlying index returns and a volatility similar to that of the underlying index. As a result - assuming the enhanced indexing strategy provides what it is designed to - the investor receives the best of what both the passive indexing and the active management worlds attempt to deliver.
As enhanced indexing has become increasingly popular among investors, so have the number and variety of enhanced indexing strategies available. These strategies can be grouped in two broad categories: Stock-based strategies and synthetic strategies. Stock-based strategies involve the ownership of the physical securities comprising the underlying index while employing some sort of stock selection technique designed to generate moderate excess returns. On the other hand, synthetic strategies 'own' exposure to the index either part or all of the time through the use of synthetic vehicles such as futures, options or swaps. Potential excess returns are then obtained either by rotating between synthetic and actual ownership of the securities in the index at opportune times or by owning the index entirely through the synthetic vehicle and adding value by actively managing the underlying 'cash' that backs the synthetic position. Of course, in order for these strategies to consistently deliver moderate returns in excess of the index in all different types of market environments, it is important that the appropriate risk controls be employed by the investment manager, also limiting the potential for any significant under-performance.
HOW TO GO SYNTHETIC
At Pacific Investment Management Company (PIMCO), our experience with enhanced indexing dates back to 1986 and involves the management of a product we call StocksPLUS. StocksPLUS is benchmarked against the S&P 500 Index and falls in the synthetic enhanced indexing category. This article details the methodology employed by PIMCO in managing the StocksPLUS product and why this type of strategy has been able to deliver consistent returns in excess of the S&P500 Index over the past twelve years, with a volatility that is virtually identical to that of the Index during a time when a significant majority of active equity managers have underperformed the same index.
To understand how this type of strategy works, it is first important to consider your options if you want to own the S&P 500 Index. Essentially, there are two readily available choices. You can purchase the physical securities that comprise the index in the appropriate capitalization weights. Alternately, you can purchase an equivalent value of futures contracts on the S&P 500 Index. In both cases you receive 100% of the price returns provided by the S&P500 Index. However, an investor that holds the physical stocks in the index differs from one that holds the futures as the investor holding the physical stocks receives the dividends paid to stockholders while the investor holding the futures contracts must forego these dividends. A second difference - and one that is key to the StocksPLUS strategy - is that instead of exchanging the entire cash investment for the physical stocks, only a small initial margin deposit (currently around 5% of the total contract value) is required in order to own the futures contracts. This allows the remaining 95% of the initial cash investment to be retained. Of course, both of these differences are taken into account in the pricing of futures contracts.
In practice, the futures contract is priced with the embedded assumption that the cash backing the contracts is invested at a short-term interest rate, typically around LIBOR (London Interbank Offered Rate). This is because the bulk of the holders of long S&Pfutures positions - equity investment managers and index arbitragers - have very short and uncertain time horizons for their holdings of futures, primarily using them as temporary substitutes for physical stocks. Therefore, if someone employing this type of strategy can invest the cash and consistently achieve returns higher than the embedded short-term interest rate and foregone dividends, then this strategy will deliver returns that are consistently in excess of the returns of the S&P500.
STAYING AHEAD OF LIBOR
There are a variety of techniques - often referred to as 'portable alpha' strategies - that can be employed by investment managers to exceed the embedded LIBOR rate assumed to be earned on the cash backing the futures contracts. While some of these strategies can be very complex in nature, the primary means used by PIMCO to add value is active management of a short-duration fixed income portfolio backing the futures contracts. The reason that this particular value added strategy has worked so effectively is twofold. First, StocksPLUS investors have a longer time horizon than the very short time horizon of the index arbitragers and second, PIMCO has expertise in fixed income management. Importantly, given these two factors - a longer term investment horizon and expertise in fixed income management - it should be the case that anyone employing this type of strategy should expect to achieve returns in excess of the index. Of course, there is no such thing as a free lunch and this strategy is no exception. It is true that some additional risk must be assumed in order to achieve a rate of return above the LIBOR rate embedded in the futures contract. However, at PIMCO we feel that capturing premium returns for assuming modest risk exposures is appropriate for an investor with a longer time horizon.
THE THREE KEY PREMIUMS
We separate the structural market risk premiums that the StocksPLUS strategy captures (to a greater or lesser extent, depending on the current market environment) into three categories: 1) the term premium (upward slope in the shape of the yield curve); 2) the transactional liquidity premium (yield which compensates an investor for holding bonds with wider bid/ask spreads); and 3) the credit risk premium.
We believe that the most efficient duration-management strategy involves a modest extension of duration beyond the average time to expiration of our S&Pfutures contracts in order to capture the term premium offered by the positively sloped shape of the yield curve under normal market conditions. As shown by Figure 1 (using annualized returns and standard deviation of monthly returns over 30 years for Treasurys as an example), by extending to six months or a year, you normally receive significant incremental return for relatively little additional volatility. Notably, as we limit our portfolio duration to one year, we avoid excessive sensitivity of StocksPLUS returns to changes in interest rates. Thus, the risk related to increasing interest rates is small over time horizons of one year or longer. Except in extreme cases, the higher yield obtained through duration extension and active management should offset any potential decline in the price of the fixed income portfolio due to rising interest rates.
The transactional liquidity premium is another structural source of excess returns. If one expects to hold futures indefinitely, after providing sufficient transaction liquidity in reserve to meet the margin flows associated with a stock market crash, the remaining fixed income securities can be invested in higher-yielding, slightly less liquid securities such as CMOs, corporate medium term notes, and other securities. These issues earn a higher yield due to their lower trading liquidity. However, because the securities in this category are short in duration, they are mostly self-liquidating. Thus, market participants who actively trade these bonds in effect subsidize PIMCO's clients who act as long-term holders via StocksPLUS. We can liquidate these holdings if necessary, but typically at a slightly higher transaction cost. Importantly, we generally maintain 50% of the portfolio in securities we feel can be liquidated quickly at minimal cost, thereby creating sufficient liquidity to meet margin flows even in a dramatic stock market decline.
Another tool for adding value in StocksPLUS is the credit risk premium obtained by holding securities that have slightly higher perceived credit risk than that of a 'risk-free' security such as a Treasury bill. Also, while StocksPLUS primarily focuses on the investment grade segment of the corporate bond market, at times we do invest up to 10% of the portfolio in BB-rated securities in Full Authority StocksPLUS portfolios. Importantly, while PIMCO mitigates basis risk by focusing on short duration, high-credit-quality assets, the modest corporate credit risk in a StocksPLUS portfolio acts to diversify the interest rate or duration risk. This is because an environment of rising short-term rates, where duration exposure would impose a cost on the portfolio, would most likely occur in a strong economic environment when credit risk was diminishing and corporate yield spreads would likely be narrowing. As a result, we generally believe that the use of short duration corporate credits offsets some of the exposure to rising interest rates and further diversifies overall portfolio risk. Historical evidence demonstrates a consistent negative correlation between these two risk exposures (see Figure 2).
An additional source of value added is obtained simply by investing in low duration securities across multiple sectors to capture the combined yield and diversification benefits. Effective use of high quality non-Treasury securities such as those offered in the mortgage sectors adds return to the portfolio with little incremental risk from spread widening (basis risk), given the modest duration of these holdings. Additionally, from time to time there are opportunities to purchase short-duration foreign bonds, hedge the currency risk, and earn a yield premium over high quality U.S. paper. Such foreign exposure, permitted by Full Authority clients to the extent of about 20% of a StocksPLUS portfolio, serves as a useful means of further diversifying a StocksPLUS portfolio, particularly during the brief periods when the short end of the U.S. yield curve inverts.
Overall, these three risk premiums plus the ability to hold a diverse group of high quality fixed income securities - rather than just placing the entire cash portfolio backing the futures contracts in an interest bearing money market account or similar vehicle - add up to a wide variety of ways to potentially exceed the embedded short term rate in the futures contract for a long-term investor. This ability to add value with respect to StocksPLUS is further enhanced by the addition of PIMCO's broad expertise in the fixed income markets. Notably, the historical excess returns of StocksPLUS are significantly higher than what a passive exposure to these three risk premiums would have delivered in the absence of active management.
WHY YIELD, NOT PRICE
Indeed, one of the major benefits of a futures-based enhanced indexing strategy is that the futures provide 100% of the price return of the S&P 500 stocks on a capitalization weighted basis. StocksPLUS and similar strategies seek to achieve excess return not by altering the price characteristics of the index but instead by altering the yield characteristics. The magnitude of risk in the yield component of the S&P500 total return is much less than that of the price component. Therefore, the likelihood of this type of a strategy underperforming the index by a significant degree is, we believe, much lower than the risk in enhanced index strategies that use actual stocks but do not fully replicate the price component of the capitalization weighted index.
A key element of the success of StocksPLUS and similar strategies is the S&P 500 futures contracts. In order for this strategy to work, the futures contracts must be an effective substitute for the physical securities, delivering the price returns of the index. Fortunately, the S&P500 Index futures have proven to be an excellent substitute for owning the physical stocks in the index. This relationship holds because, when the index futures contracts expire every quarter, the final price is set equal to the value of the S&P500 stock index. Although in the short term there can be some deviations between the cash index and the futures, over the long term the structure of the futures contract assures that the futures 'track' the stocks.
The fact that there are times when the futures are not priced at the theoretical equivalent to the stocks provides an additional opportunity to add value. By properly selecting the points at which to 'roll' from the current or 'nearby' S&P futures contract to one with a more distant expiration date, it has been possible to buy the deferred contracts when they are cheap relative to their theoretical value. However, going forward we do not expect rolling futures to be as significant a contributor to performance. Rather, we expect the spread between the nearby and the deferred S&P futures contracts to fluctuate within moderate range of fair value, sometimes adding slightly to our returns and sometimes detracting modestly.
PIMCO has been managing StocksPLUS portfolios for over 12 years. From inception on July 10, 1986 to September 30, 1998, we have produced an average annualized excess return over the S&P500 of 177 basis points before fees and 134 basis points after fees for full authority accounts. More impor tantly, the excess returns have been highly consistent. Our StocksPLUS Full Authority Composite has outperformed the S&P 500 in 132 of the 138 rolling 12-month periods ending July 31, 1987 through December 31, 1998. This track record has been compiled over a period that included some severe tests for the strategy, including the 1987 stock market crash and 1994' extreme rise in short-term interest rates.
For offshore investors, StocksPLUS offers a significant additional benefit over a traditional stock portfolio. Whereas, in many jurisdictions, dividends paid on stock holdings are subject to withholding taxes of between 15% and 30%, the two sources of StocksPLUS returns (S&P futures margin flows and interest income) are generally free from withhold ing. The specific tax treatment of an investment in StocksPLUS may vary from investor to investor. This added benefit can immediately improve returns over the S&P500 by quite a few basis points without even taking StocksPLUS potential excess returns into account.
PIMCO's clients use StocksPLUS for a variety of purpos es. StocksPLUS has a high correlation (99.4% from July 31, 1986 to December 31, 1998) to the S&P 500 and a standard deviation of monthly returns (4.5%) virtually identical to that of the index. These characteristics make the approach quite suit able for a core, large capitalization equity component of client's asset allocation. At December 31, 1998, PIMCO was managing StocksPLUS portfolios totaling $15.8 billion for 71 clients. Past performance, of course, is not a guarantee of com parable future results.