benefits of active management - pimco

8/9/2019 Benefits of Active Management - PIMCO

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The Benefits of Active Management

PIMCO has always believed actively managed bond portfolios should provide returnsover and above those of passively managed portfolios, particularly over the longerterm.

PIMCO has identified three specific reasons why active management strategies arelikely to produce higher returns than passive strategies, with limited changes to overallportfolio risk:

Bond Market Inefficiencies: Inefficiencies in the bond market, often the resultof restrictions on passive strategies, provide both structural and tacticalopportunities to generate returns that should exceed those of benchmarkindices.

Diverse Sources of Added Value: Active managers with extensive resourcesand expertise across all sectors of the market can identify many small anddiverse sources of added value, which should boost returns on a consistentbasis without significantly altering risk levels. This philosophy is embedded inPIMCO's approach to core active management.

Passive Management Limitations: Passive strategies often sacrifice return

because of restrictions on the securities they can invest in, while a structural tilttoward higher-yielding issues can add unexpected risks that most passivemanagers lack the resources to evaluate.

Bond Market Inefficiencies = Structural and Tactical OpportunitiesIn contrast to the equity market where structural inefficiencies are less pronounced, thebond market offers ample structural inefficiencies for an active manager to exploit.Tactical opportunities to add value are equally plentiful, particularly when marketsentiment turns excessively negative or positive. These opportunities are not alwaysobvious to those with a short-term investment horizon. But a resourceful activemanager, working with an institutional time horizon (three years or more), canfrequently exploit inefficiencies and excesses in many small ways that not only provideconsistent performance but also help to maintain a level of risk similar to the underlying

benchmark.

PIMCO believes there is a significant distinction between "core" and "non-core" activemanagement. PIMCO's active management philosophy is to identify as manyopportunities as possible to add value relative to the benchmark. We consider this a"core" approach because we diversify our sources of excess return by taking manysmall deviations from the benchmark index, rather than one or two large positions, a"non-core" approach, which can cause a significant divergence between portfolio andindex returns. We believe our approach is far better suited to core fixed-incomeallocations because it tends to track the targeted index while attempting to provide


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enhanced returns, helping to ensure that our actively managed portfolios perform asexpected relative to other markets and asset classes and do not include aggressivepositions that might skew those relationships.

The fixed income market includes a wide variety of securities, from nominal and real-return Treasuries and mortgage-backed securities to bonds from corporate andemerging market issuers. Each sector has its own distinct risk and returncharacteristics. The degree of inefficiency varies from sector to sector as well. Activemanagers with access to the full spectrum of fixed income securities have a much

broader opportunity set than passive strategies, which are limited by the index, not onlyfor seeking additional returns but for diversifying risks as well.

Structural Opportunities to Add ValueMany of the bond market's structural inefficiencies result from the fact that some of themarket's largest participants have different investment objectives and are restricted, orrestrict themselves, in various ways. These "clientele effects" can create pockets ofvalue where demand is artificially suppressed. This contrasts with the greater focus inthe equity market on wealth creation with fewer parameters. Additionally, bond marketinvestors with a shorter investment and performance time horizon than PIMCO candistort prices over the short term, creating opportunities to capture long-term value.

PIMCO has identified four specific structural aspects of the bond market that commonly

allow the active manager to provide more return than passively managed portfolios:

Term Premiums: The front-end of the yield curve offers a number ofopportunities to capture term premiums created by a positively sloped yieldcurve, where longer-term interest rates are higher than shorter-term rates. Forexample, some large institutional investors are often restricted from holdingmaturities longer than 13 months. As a result, investors with more flexibility canearn higher returns by buying issues with 14-month or longer maturities.

Liquidity Premiums: Benchmark bond indexes often include only the largest,most actively traded securities, and many investors similarly limit themselves tothese issues and are forced to pay a price premium for maximum liquidity thatis often unnecessary. The reverse is also true: as an active manager, PIMCO

has the discretion to purchase securities with slightly less liquidity and therebyearn a yield premium for our willingness to invest in issues from which othersare restricted.

Volatility Premiums: PIMCO has found that it often pays to "sell volatility" inthe bond market because investors usually overpay for price stability. Holdingissues with embedded call or put features, such as mortgage-backedsecurities, or collecting premiums by selling options outright, is another sourceof added return largely unavailable to passively managed portfolios.


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Credit Premiums: Many investors and passively managed portfolios limitthemselves unnecessarily to only top-rated credits. For example, most will notbuy issues rated as "junk" (less than investment grade) by one rating agencyeven if another agency rates the issues as investment grade. As an activemanager, PIMCO has the flexibility to purchase such "split-rated" bonds whenwe believe we will be more than compensated for taking additional credit risk.Our in-house credit analysis group, using a conservative and highly selectiveapproach, is often able to identify opportunities to add substantial additionalyield by assuming only modestly higher credit risk. We diversify this risk by

limiting exposure to any particular company or sector.

Tactical Opportunities to Add ValueIn addition to these structural inefficiencies, active bond managers can take advantageof tactical opportunities to add value that are typically unavailable to passive strategies.For example, passive strategies usually prevent the use of derivatives. But when usedprudently, futures, options, swaps and forward-settled mortgage securities providesophisticated tools for both adding return and managing risk.

One way to add value by using derivatives might be to gain exposure to a particularmaturity through futures, which are often cheaper than actual cash bonds but providethe same interest rate exposure. The institutional time horizon can be nicely exploitedto earn additional return by backing forward liabilities implicitly built into Treasury

futures contracts with cash or higher yielding bond equivalents that should earn muchmore than the financing rate embedded in the futures contract. Interest rate swaps canbe even more flexible than futures because they provide a complete yield curve whileTreasury futures offer only two-year, five-year, 10-year and 30-year maturities.

Other tactical strategies may be based on broad macroeconomic views. These viewsform the basis for identifying which maturities, sectors, or countries are most likely tooutperform over the long-term. PIMCO makes particular use of this approach becausewe tend to have an investment horizon that is flexibly longer on average than manyother market participants. By assessing opportunities within the framework of our three-to five-year secular outlook, we are often able to identify securities that have beenmispriced by those with shorter-term views or less flexibility.

PIMCO's Approach to Core Active ManagementReturns on different sectors of the fixed-income market are often not closely correlatedwith one another or with equities, offering potentially significant opportunities to reduceportfolio volatility. While active management strategies provide opportunities to earnexcess returns, reduce risk and improve diversification, not all investment managersare equally equipped to exploit these potential benefits.

The following distinct set of characteristics can distinguish an effective core activemanager:


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Organizational Scope and Firm StructureMany market inefficiencies are subtle and transitory. The kind of firmmost likely to produce superior results is one in which the manager has awide, multi-sector playing field and the flexibility to rotate among marketsegments to exploit anomalies as they arise. PIMCO's expertise acrossall market sectors allows us to systematically evaluate competinginvestment prospects identified by our sector specialists and allocatefunds accordingly. PIMCO can also shift portfolio exposures easily

among sectors to seize market opportunities. By contrast, firms withfewer resources and narrower sector coverage are disadvantagedbecause the range of ideas from which they can choose is moreconfined.

Investment Philosophy, Process and ApproachAnother key aspect of an effective asset manager is a disciplinedapproach to identifying value and executing positions. PIMCO'sphilosophy is to take a long-term, top-down, view of the market,embodied in our three- to five-year secular forecast. PIMCO hasacquired top specialists in every sector of the bond market and theseexperts gather for nearly a week every year at our Secular Forum togenerate our long-term forecast. Additionally, Cyclical Forums are held

on a quarterly basis to identify shorter-term trends. These top-downviews are then combined with the bottom-up views generated by oursector specialists and quantitative and credit research to identify theoptimal strategies for implementing our long-term views in a consistent,disciplined and cost-effective way.

Risk Management and ControlsSuccessful active management also requires the ability to continuallymonitor portfolios on the basis of individual security and total portfoliorisk and strategy correlations. Measurement and management of overallportfolio risk is a major emphasis at PIMCO. Our portfolio managers areintegrally involved in the risk management process, working directly withour Financial Engineering Group to create models that are theoretically

sound, return-driven and based on market realities. Importantly, whileour portfolio managers have extensive input into our analytics, ourorganizational structure separates the risk monitoring function fromportfolio management. This separation of powers assures that those whomonitor portfolio compliance with risk parameters are not beholden tothose who manage the portfolio. This system of checks and balances isnot always found at newer or smaller firms, but PIMCO believes it is thebest way to maintain compliance with portfolio risk parameters andprotect the reputation we have established over 30 years in the bondmarket.


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A Look at Passive ManagementSome investors assume that passive fixed-income strategies are inherently less riskythan active strategies because of the breadth of portfolio holdings and market-trackingcharacteristics of passive management. But passive strategies are subject to the sameinterest rate and/or credit risks inherent in all fixed income investing, and pose otherdistinct risks and opportunity costs as well.

Passive managers typically pursue one of two broad strategies: a "laddered" portfolio of

bonds with staggered maturities or a portfolio that attempts to replicate a bond marketindex. Both strategies have limitations.

Laddered strategies typically rely heavily on relatively low-yielding U.S. Treasurybonds, particularly the most liquid "on-the-run" securities. As noted above, the mostactively traded securities typically command a high price for their liquidity and providelower yields in return.

Managers who attempt only to replicate a benchmark index are also subject to a set ofdistinct risks and opportunity costs. The major bond market indices are slow toincorporate new sectors and new types of securities. This can render whole portions ofthe fixed income universe inaccessible to passive managers, limiting diversification.Some examples of securities passive managers have been slow to adopt include

mortgage-backed securities, asset-backed securities and commercial mortgage-backedsecurities. Moreover, because institutional demand for new instruments is sparse andthe securities are less well understood, and less fully valued, passive managers mayforego potential opportunities to enhance returns.

On the other hand, institutional demand for the same securities included in mostindexes tends to be strong, creating competition for these "must own" issues, whetherthey be Treasuries, agencies, mortgages or corporates. This competition amongbuyers tends to make securities included in indexes more expensive. In an effort toimprove returns, some passive managers "tilt" portfolios by including more agency,corporate or mortgage debt. But when applied structurally rather than tactically, thestrategy relies on the weakest aspects of both active and passive approaches,producing only modestly higher yields while putting total return at risk by adding credit

risk and volatility that most passive managers are less able to evaluate.

Passive management strategies are not without merits, particularly in the equity marketwhere it can prove extremely difficult to consistently outperform the broad marketthrough stock selection. In contrast to bond indices, which capture only a portion of theinvestible fixed income universe, equity indices represent the full opportunity set. Apassive equity manager can thus directly replicate an index by holding all of itscomponent securities. In PIMCO portfolios with an equity component, we attemptmerely to match a broad equity index. All efforts to provide additional return over theindex are made with fixed-income vehicles rather than stock selection, because we


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believe structural opportunities to add value are simply not available in the equitymarket to the extent they are in fixed-income.

Conclusion: The Active Management AdvantageOver time, the bond market offers active managers significant structural and tacticalopportunities to potentially produce higher returns than passively managed portfolios.Core active managers can exploit a number of inefficiencies in the bond market toconsistently provide excess returns relative to a targeted benchmark, while maintaininga risk profile similar to the benchmark.

Prudent active management requires diverse sources of added value, vigorous riskmanagement, a long-term view and a robust process for evaluating opportunities onboth a top-down and bottom-up basis. Attempts to add value should consist of smalldepartures from the underlying index because large deviations can significantly alterrisk levels and correlations to other markets and asset classes. A core active managerwith expertise in all sectors of the fixed income market both domestically and abroad ismore likely to identify a sufficient number of diverse opportunities to add value thanthose with a narrower focus and limited resources.

Passive management strategies have many inherent limitations and are subject to thesame interest rate and credit risks common to all fixed-income investing. Passivemanagers typically have restrictions on the types of bonds in which they are able to

invest, and often must purchase, at a premium, those issues that are most in demand.These restrictions limit the opportunities available to passive managers, both to addvalue and to diversify risk. Passive managers that attempt to overcome theserestrictions by deviating from an index through additional exposure to agencies,corporate bonds or mortgage-backed securities, may be taking risks they do notunderstand, or their clients do not anticipate.

PIMCO's long-term approach to core active management, global scope and expertisein all fixed income market sectors allow us to identify a broad and diverse array ofopportunities to add value. PIMCO has invested heavily in proprietary, quantitativeanalytics and risk controls, in-house credit analysis and market expertise in order tomake every effort to consistently generate excess returns without materially altering thelevel of portfolio risk.

Past performance is no guarantee of future results. This article contains the current opinions of PIMCOand does not represent a recommendation of any particular security, strategy, or investment product. Suchopinions are subject to change without notice. This article is distributed for educational purposes only andshould not be considered as investment advice or an offer of any security for sale. Information containedherein has been obtained from sources believed reliable, but not guaranteed.Each sector of the bond market entails risk. Municipals may realize gains & may incur a tax liability from timeto time. The guarantee on Treasuries & Government Bonds is to the timely repayment of principal andinterest. Shares of the portfolio are not guaranteed. Mortgage-backed securities & Corporate Bonds may besensitive to interest rates. When interest rates rise the value of fixed income securities generally declines.There is no assurance that private guarantors or insurers will meet their obligations. An investment in high-


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yield securities generally involves greater risk to principal than an investment in higher-rated bonds. Investingin non-U.S. securities may entail risk due to non-U.S. economic and political developments and may beenhanced when investing in emerging markets. Portfolios may use derivative instruments for hedgingpurposes or as part of the investment strategy. Use of these instruments may involve certain costs and riskssuch as liquidity risk, interest rate risk, market risk, credit risk, management risk and the risk that a fund couldnot close out a position when it would be most advantageous to do so. Portfolios investing in derivativescould lose more than the principal amount invested. No part of this article may be reproduced in any form, orreferred to in any other publication, without express written permission. Pacific Investment ManagementCompany LLC. 2003 PIMCO.

benefits of active management - pimco

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