PIMCO Research Affiliates Equity (RAE) Fundamental Seek to get more from your equity allocation with a systematic strategy that is designed to capture the key benefits of a passive equity approach, with the potential for meaningful excess return.
2 A strategy for the current environment Since the 2009 market bottom, equities have returned well above historical averages. As a result, investors with simple market beta exposure likely achieved their return objectives. And, because of widespread underperformance, investors using traditional active equity managers would have been better off in passive index strategies. In fact, recent trends indicate that investors are increasingly allocating to passive equity. Importantly, one of the key concerns for investors is whether the equity markets will continue to deliver above average returns going forward. If markets deliver lower returns, as PIMCO believes, market beta may not be sufficient. Systematic active equity strategies like PIMCO RAE Fundamental are designed to give investors some of the benefits of passive investing, such as broad diversification, economic representation and lower fees versus traditional active management, with the potential for excess returns.
3 PIMCO Research Affiliates Equity (RAE) Fundamental: A systematic approach to equity investing Research Affiliates pioneered smart beta when it developed systematic rebalancing strategies in 2004. The original concept: A stock selection and weighting approach that was not linked to price and a thoughtful, efficient implementation process. Their goal was to design a better-performing strategy that could take advantage of short-term mispricings and market distortions common in capitalization-weighted indexes yet preserve diversification, low turnover, lower fees and other benefits of passive investing. Over the ensuing decade, Research Affiliates incorporated additional insights into equity investing that created a more active approach in RAE, exclusively available through PIMCO. PHILOSOPHY OF RAE FUNDAMENTAL 1 2 3 Select and weight stocks by non-price measures of company size (i.e. economic footprint) Incorporate quantitative enhancements to improve portfolio returns Rebalance the portfolio back to fundamental weights, contra-trading recent price movements Price Short-term mispricing Fair value Price STEP 1: WEIGHT STOCKS BASED ON FUNDAMENTAL SIZE RAE begins by weighting stocks according to their economic size, such as sales, cash flow, dividends and book value, rather than their price-driven market capitalization (Figure 1). These measures provide a balanced and stable representation of a company s economic footprint, therefore breaking the link between price and portfolio weight. As near-term sentiment drives stocks above or below their fair value, this rules-based approach systematically sells overpriced stocks and buys underpriced ones converting the market s tendency of mean reversion into a source of excess return. Rebalancing back to fundamental size results in trading against the market s most extreme bets. This contra-trading produces a value bias relative to the cap-weighted market. As a result, this first step seeks to generate outperformance over time by capitalizing on short-term equity market inefficiencies.
4 FIGURE 1: STEP ONE BEGIN WITH FUNDAMENTAL SIZE Target stock market universe Rank all stocks on four fundamentals, equally weighting the four size measures Sales (5-year trailing) Dividend (5-year trailing) Cash flow (5-year trailing) Book value (current) Select top companies by fundamental weight Top companies by fundamental size STEP 2: REFINE THE WEIGHTS After weighting stocks by fundamental size, the strategy then applies well-researched active insights into quality, momentum and diversification of active share to refine certain aspects of an otherwise simple rebalancing strategy (Figure 2). PIMCO and Research Affiliates believe these insights increase return potential without increasing risk. The goal is to deliver attractive excess returns relative to the market (i.e., the core cap-weighted index). Whereas naïve rebalancing rules are static and do not change, RAE enhancements are live and evolve to incorporate the portfolio managers ongoing research into improving risk-adjusted returns. The RAE portfolio construction process uses multiple measures of quality to reduce or eliminate weights to value traps companies that are justifiably cheap and less likely to mean revert to past economic size. Insights on quality are obtained by the current score of a company s financial health. A poor quality score acts as a punitive guardrail against companies with distressed balanced sheets, aggressive accounting practices or poor growth prospects. Consequently, quality enhancements boost exposure to companies that appear to be relatively healthy. The process also recognizes that the market can be slow to react to new information, exhibiting short-term persistence in their performance. Simple rebalancing strategies that systematically buy low and sell high typically result in trading against such market momentum. Therefore, RAE incorporates momentum into the portfolio construction by increasing weights in stocks that have outperformed over the past year and lowering weights in stocks that have underperformed. This process reduces the risk of catching the proverbial falling knife or taking profits early and missing additional upside. The net result is that RAE s momentum insight gives the portfolio a neutral exposure to momentum. Research Affiliates has found that value stocks tend to be correlated and clustered in certain sectors of the market. This often results in value strategies that are highly exposed to the value factor. In addition, cheap growth-like stocks offer more upside potential when prices mean revert. RAE s diversification of style insight allocates away from expensive value-like stocks and toward cheap growth-like stocks. In addition to rebalancing, this insight contributes to RAE s dynamic exposure to value, increasing the value bias when value stocks are cheapest and decreasing the value bias when value stocks are expensive. Finally, weighting stocks by their fundamental size typically results in significant absolute active weights in the largest companies of a given market. Larger companies are often more efficiently priced than smaller ones, offering less benefit when prices mean revert. RAE tends to redistribute active weights from larger companies into smaller companies that are more likely to be mispriced. This diversification of size insight aims to increase active weights in less efficient areas of the market. Because RAE redistributes both overweights and underweights across the portfolio, this insight does not meaningfully impact the portfolio s weighted average market cap.
5 FIGURE 2: STEP TWO ADD ACTIVE EQUITY RESEARCH INSIGHTS Begin with Fundamental Size Select and weight stocks based on sales, cash flow, dividends and book value + + + + Quality Enhancement Reduce or eliminate weights to companies that may be under financial stress, employ aggressive accounting, or lack growth prospects Momentum Enhancement Avoid trading against short-term momentum by delaying the rebalance of stocks with recent price momentum (to avoid catching the proverbial falling knife) Style Diversification Reduce the portfolio s reliance on the value factor by redistributing weights away from expensive value stocks towards cheap growth stocks Size Diversification Redistribute active risk from more efficient large cap stocks to less efficient smaller cap stocks STEP 3: IMPROVE REBALANCING Many rebalancing strategies typically rebalance once per year, but the timing of a rebalance can have a significant impact on shortterm performance. For example, extreme market dislocations can result in sensitivity to a single ill-timed rebalancing date. As opposed to a simple once-a-year rebalance, RAE employs an improved rebalancing process that spreads it across all four quarters, reducing market impact and mitigating trading risk. An RAE portfolio is divided into four identical tranches; each tranche is a full-fledged model portfolio and is traded once a year. At each quarterly rebalance, RAE s active insight screens are refreshed to incorporate current data. Research Affiliates has found that this staggered approach to rebalancing results in lower implementation costs and increased capacity, while keeping portfolio turnover low.
6 How do clients use PIMCO RAE Fundamental strategies? PIMCO RAE Fundamental strategies are available across a range of equity exposures, including U.S. large cap, U.S. small cap, international, emerging and global markets and can serve a number of important roles in a portfolio. Replacing traditional active managers Enhancing the core PIMCO RAE Fundamental takes a systematic approach, which results in a completely emotionless, disciplined strategy that seeks to consistently buy low and sell high. In the environment ahead, beta alone may no longer be enough, and passive allocations may not deliver the returns investors need to meet their goals. PIMCO RAE Fundamental strategies may serve as a core solution, providing many of the benefits of passive, such as broad diversification, economic representation and low turnover, while adding the potential for needed excess returns. Benefiting from the return of the value premium Given their dynamic exposure to value stocks, PIMCO RAE Fundamental strategies can be a reliable way to benefit from potential value outperformance. The rules-based aspect of the process and the active insights that are applied result in portfolios that load up on value stocks when they are cheap, but also reduce that deep value bias when value stocks become more expensive.
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Past performance is not a guarantee or a reliable indicator of future results. A word about risk: Investing in the bond market is subject to certain risks including the risk that fixed income securities will decline in value because of changes in interest rates; the risk that fund shares could trade at prices other than the net asset value; and the risk that the manager s investment decisions might not produce the desired results. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. 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