Equities: Enhancing the Core/Satellite Framework March 13, 2015 by Sabrina Callin, Andrew Pyne of PIMCO In a lower-returning environment, investors may need to look beyond traditional active or passive approaches in order to capture equity alpha. The building blocks of equity alpha include high active share stock selection, smart beta-based strategies and portable alpha approaches. These complementary sources of alpha can be implemented in an enhanced core/satellite framework to allow investors to pursue the returns needed to meet their objectives. Equities have delivered strong returns since the market bottomed in March 2009, making beta exposure more than sufficient for many investors to achieve their return targets. At the same time, active managers on average have trailed equity indexes, leading some to raise skepticism about the benefits of active management versus passive market indexed strategies. Looking forward however, with sluggish global growth likely leading to modest earnings growth, we expect equity returns to be meaningfully lower than the past few years, and alpha to be increasingly important in equity portfolios. While PIMCO s New Neutral thesis of low real interest rates for the long term is supportive of current fuller equity market valuations, for the road ahead, beta may not be enough: Achieving alpha from equity allocations will likely be necessary for investors to meet their return objectives. There are impediments but also solutions to harnessing equity alpha The challenge for many investors is there are a number of reasons their equity portfolio may not be positioned to achieve alpha, including: Large allocations to passive market cap weighted strategies which, by design, modestly underperform the market after fees and transaction costs Benchmark hugging active equity managers, who have difficulty outperforming after fees A portfolio construction framework comprising too many strategies, essentially creating expensive equity index exposure Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
A manager selection process that leads to poorly timed hiring and firing decisions, and an insufficient time horizon that doesn t allow for style headwinds to mean revert. Such structural impediments to performance have not necessarily been problematic in the recent environment of high equity market returns and low volatility. But facing an environment with lower expected returns, and potential for bouts of volatility, how can investors find the alpha needed to enhance market returns and make the most out of the equity market risk they are underwriting? Equity alpha Investors may need to look beyond traditional active or passive approaches in order to capture equity alpha. At PIMCO, we believe there are several independent and complementary sources of alpha that investors can access to help outperform the broader market. These building blocks of equity alpha include high active share stock selection, smart beta-based strategies and portable alpha approaches. High active share stock selection As our industry has become more focused on tracking error and relative returns, active managers are taking less active risk, which is evident in the steady decrease in the percentage of equity strategies that have high active share (the percentage of holdings in a portfolio that differ from the benchmark index). Sizing positions based on research conviction rather than benchmark weight typically results in high active share, which is an important indicator of the potential for outperformance. This stands to reason as a manager who emphasizes their positions of highest conviction regardless of benchmark representation should produce superior results over the long term if their convictions are well founded. So, while the average active equity manager may underperform, multiple studies have shown that the average high active share manager outperforms after fees. In a recent Cambridge Associates study, institutional managers were grouped into quartiles by active share, and the results showed the average highest-quartile active share manager outperformed the lowest-quartile active share manager over a time period that includes both bear and bull markets (Figure 1). Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
Smart beta-based strategies There are a range of views on the term smart beta and whether these systematic, rules-based approaches to achieving market outperformance should be viewed as active or passive. Regardless of the terminology used, there is a very logical basis to why these strategies may outperform the market across periods of reasonable length. By design, smart beta strategies take a valuation indifferent approach to portfolio construction. In breaking the link between stock price and portfolio weight, smart beta strategies avoid the performance drag inherent in capitalization-weighted indexes that necessarily overweight overpriced stocks and sectors and underweight underpriced stocks and sectors. Assuming the stock market is not perfectly efficient think the Japan bubble in the 80s, technology in the 90s or financials in the 00s smart beta strategies seek to avoid the ultimate, and sometimes quite painful, re-pricing of stocks and sectors in an effort to reflect more realistic economic value. One well regarded example of a smart beta approach that has consistently and meaningfully outperformed the market by capitalizing on these observable market inefficiencies is the Research Affiliates Fundamental Index (RAFI), which selects and weights stocks based on company sales, cash flows, book value and dividends (Figure 2). Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
Portable alpha Another way for equity investors to capture sources of excess return is through a portable alpha approach. Rather than obtaining equity exposure by purchasing common stocks, portable alpha strategies obtain equity exposure synthetically, typically via futures or swaps. The economic exposure is very similar to owning the underlying stocks the difference lies in the payment structure. With a common stock portfolio the payment is made at time of purchase. In a portable alpha strategy, instead of up-front payment, there is a money-market rate financing cost associated with a futures and swapbased stock portfolio. This method of gaining equity exposure allows the manager to run an independent, complementary strategy designed to generate alpha in addition to receiving the returns of the equity portfolio. In essence, if the returns of the alpha strategy exceed the money-market cost of the equity exposure plus management fees, then the strategy overall will outperform (Figure 3). For example, in a portable alpha equity construct an absolute return oriented bond alpha strategy may capture persistent, structural return opportunities relative to a money market rate and at the same time provide equity risk diversification benefits. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
Structuring an equity portfolio for higher returns Investors can utilize these building blocks of equity alpha as a guide to hire managers and select strategies, and they can potentially improve returns by putting them together using an enhanced core/satellite framework. Traditionally, core/satellite portfolios have had passive at the core and a collection of active managers as satellites, which depending on manager selection may or may not have generated alpha. In the recent environment, this construct generally delivered sufficiently high returns just on the strength of the beta component. But for the environment ahead, we think investors need to be more thoughtful in structuring their equity portfolio in order to capture alpha from both their core and satellite allocations. To enhance this framework, we believe it is important that the core of the portfolio continues to have economically representative and diversified equity exposure. Rather than traditional passive, however, implementing this exposure with smart beta-based and/or portable alpha equity approaches provides the potential for meaningful and valuable alpha (Figure 4). Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.
One of the benefits of both smart beta-based and portable alpha approaches is the potential for excess returns that are structural in nature. The inclusion of these alpha generating core strategies can be helpful not only in providing additional diversified sources of return but also in allowing adequate time for the realization of the longer-term value proposition of skilled high active share managers with disciplined investment processes and high quality research. In addition to incorporating high active share strategies, we believe satellite allocations should be diversified across investment styles, such as value, growth, and outcome-oriented approaches like dividend income, low volatility and long/short equity strategies. The combination of high active share satellites with a smart beta and portable alpha core may contribute to more consistent and more meaningful alpha generation from investors equity allocations overall. Conclusion Equities will always be an important part of investor portfolios given the returns they provide over the long term. But after a very strong run for the equity markets, the road ahead suggests a lower return environment and the need for alpha. By clearly identifying the repeatable drivers of equity alpha the building blocks and structuring equity allocations within a disciplined framework, investors can pursue the returns needed to help meet their objectives. Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic and industry conditions.absolute return portfolios may not fully participate in strong positive market rallies. Investing in thebond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. Bond investments may be worth more or less than the original cost when redeemed.swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.
advantageous. Investing in derivatives could lose more than the amount invested. Smart beta refers to a benchmark designed to deliver a better risk and return trade-off than conventional market cap weighted indices. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. FTSE RAFI U.S. 1000 Index, FTSE RAFI Emerging Markets Index and is part of the FTSE RAFI Index Series, launched in association with Research Affiliates. As part of FTSE Group s range of nonmarket cap weighted indices, the FTSE RAFI Index Series weights index constituents using four fundamental factors, rather than market capitalization. These factors include dividends, cash flow, sales and book value. The FTSE RAFI 1000 Index comprises the largest 1000 publicly traded U.S. companies by fundamental value, selected from the constituents of the FTSE U.S. All Cap Index, part of the FTSE Global Equity Index Series (GEIS). The total return index calculations add the income a stock s dividend provides to the performance of the index. The FTSE RAFI Emerging Markets Index is designed to provide investors with a tool to enable investment in emerging markets whilst using fundamental weightings methodology. The FTSE RAFI Emerging Index consists of the 350 companies with the largest RAFI fundamental values, selected from the constituents of the FTSE Emerging Index. The FTSE RAFI All-World 3000 Index comprises 3000 companies with the largest RAFI fundamental scores selected from the FTSE Global All Cap Index. It is not possible to invest directly in an unmanaged index. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.
States and throughout the world. 2015, PIMCO. Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.