Products & Services About PIMCO Press Center Bond Resources Career Information Content Archive PIMCO Foundation
Viewpoints
Many investors are looking for new solutions designed to better position their portfolios to take advantage of opportunities and protect against risks and uncertainties. In this interview, PIMCO product managers Bruce Brittain, Jim Moore and Mark Taborsky discuss some innovative solutions for investing in the New Normal economic environment and address some of the questions and concerns we're hearing from clients in 2010.
Q: What are some ways for investors to re-evaluate their asset allocation strategies in light of the broad secular shifts PIMCO sees taking place?Taborsky: In this environment of continued turbulence and uncertainty in the economy and the markets, we've found that a risk factor"â??based approach to asset allocation may prove helpful to clients in aligning their portfolios with their overall objectives and with their broad macroeconomic views. Careful portfolio analysis can, with a fair degree of precision, show investors where they are exposed to various risks and help them redefine strategies or allocations as needed to confront those risks or potentially seize opportunities. We're in one of those periods in the evolution of asset allocation where things are clearly changing, and it helps to think a little differently about assets and drivers of returns.
Macro views may be more important now than they've been in the past 15 years; investors need to look at both the short term and the long term and think about those views in risk factor terms. For example, if inflation is the primary concern, investors can add real rate duration to their portfolio. If they're worried equity markets will correct again, they can adjust equity risk factor exposure "â?? looking not just at the public equity asset class, but at the equity risk in public equities, in high yield bonds, in real estate, in hedge funds and in private equity investments.
Brittain: As investors look for new approaches to asset allocation, they are seeing that economic developments can create opportunities that fall outside traditional investment categories. For example, subsets of the markets for corporate credit, banking sector assets and commercial real estate are under stress and this could generate intriguing investment prospects. Be alert to these rare, "once-in-a-crisis"? investments and think about where they fit into a broader strategy.
With this investment environment in mind, we are working with clients to design and implement solutions that may encompass multiple asset classes and risk exposures. In particular, we're attempting to go beyond traditional asset allocation approaches by decomposing portfolios and analyzing investment opportunities in terms of the risk factors they embed. We are developing hedging strategies and developing investment alternatives that may all contribute to these more evolved and comprehensive approaches to solving investment problems.
Q: How do tail risk hedging strategies fit into an asset allocation solution?Brittain: Tail risk hedges "â?? portfolios of option-like securities that have asymmetric payoff patterns "â?? may complement asset allocation strategies. To hedge against risk in the traditional asset allocation approach, an investor might consider selling risky assets (buying less risky assets and moving off the efficient frontier), buying momentum strategies and buying flight-to-quality assets, like short-dated Treasury securities. As a complement to these strategies, an investor might consider buying a portfolio of option-like securities and maintaining exposure to risk assets at a higher level. Investors gravitate to these strategies because they are designed to provide liquidity during periods of crisis and allow the investor to play offense, buying risk assets when their prices are down.
At PIMCO, we construct these portfolios of option-like instruments by using the deep and liquid options markets. In building these portfolios, we take account of investor hedging budgets, the specific exposures expressed in their portfolios and their desired hedge levels. We try to hedge the principal risk factors directly "â?? with instruments that explicitly address the dominant elements of risk. But frequently we use indirect hedges because they can potentially be useful in mitigating the cost of direct hedging strategies. After all, during financial crises, the factors driving risk assets tend to correlate, losing their unique characteristics; implied price volatilities tend to rise across all options markets and, under some circumstances, an option on one risk factor might serve to hedge exposures to another risk factor. Indirect options may sometimes be priced favorably enough to introduce "basis"? risk into the hedging strategy. Our outlook for the New Normal suggests there is enough potential for future tail events to warrant hedging strategies for many investment portfolios.
Q: Is a re-evaluation of benchmarking strategy a part of this broader solutions approach?Taborsky: Investors should not only know what's in their benchmarks but also maintain an active, forward-looking approach, assessing likely trends and biases in those benchmarks. In a fixed income benchmark, for example, we may see increasing biases toward countries that are becoming more indebted, whose credit fundamentals are getting worse. And in the equity markets, cap-weighted benchmarks demonstrate certain biases. They tend to be overweight expensive companies and underweight cheap companies. In both cases there are fundamental benchmarks that may correct for these biases. Note also how a fundamentally weighted index in a global bond portfolio will likely bias investors to have more in emerging markets bonds than an issuance-weighted index. This makes sense because emerging market countries have been growing faster than developed markets and their credit fundamentals have been getting better while those of developed markets have been getting worse. Investors may want to move into indexes that have more forward-looking views of likely developments in the asset markets, and more appropriately position themselves to take advantage of those developments.
Moore: You can see another interesting characteristic in benchmark biases if you look at, for example, the S&P 500 compared with the Barclays Aggregate. Even though the equity index is cap-weighted, the market is determining the weighting. In the fixed income index, capital structure decisions by the issuers determine the weightings: If a corporation or government decides to change their capital structure and issue more debt, then the passive index investor essentially accedes to that. Such issuer-determined weightings essentially present an even greater bias than you find in market-weighted (versus fundamental) indexes.
Brittain: Another way in which many clients are thinking about the benchmarking issue is to become less benchmark-centric and allow more discretion to the manager. I've seen very significant interest for mandates in which the portfolio manager has the flexibility to take exposures to a particular factor, say duration, down to zero or even negative. And that flexibility resonates with the client base because that gives the flexibility and the opportunity to the portfolio manager to look to avoid long exposure to duration in a rising rate environment, for example. It also provides the flexibility to move outside of traditional Aggregate sectors to take more meaningful exposure to emerging markets, high yield and non-U.S. securities if the portfolio manager sees value.
Q: How do alternatives fit into an allocation strategy, and are there concerns over illiquidity in longer-term alternative investments?Taborsky: The point of alternatives is to take advantage of the liquidity premium, to take a longer-term investment horizon, and to do things that normal, long-only liquid market investors cannot do. Because we think the New Normal is going to be a bumpy period in terms of economic recovery and investment returns, there are bound to be deep value, relative value, shorting and distressed opportunities that only alternative strategies and structures can look to exploit.
In private equity, we believe funds are going to have trouble raising money in the future; many have legacy issues that will take time to work out. We may see good opportunities arising when investors need to get out of their longer-term private equity commitments.
We also may see many kinds of opportunities in natural resources, real estate (mindful of the refinancing that will take place on a large scale in the coming years) and in other spaces. But each situation will be different, and most such opportunities are likely to have longer-term horizons.
After the crisis, there isn't as much willingness for investors to embrace illiquidity. So while liquid markets have rallied a lot, illiquid assets will lag as their liquidity premium gets re-rated. It's going to take time for capital to return to less liquid and longer duration strategies. This itself is an opportunity "â?? the fewer the bidders there are for long-term cash flows, the higher the expected return an investor may be able to command.
Q: Do currencies have a place in a broad asset allocation approach?Taborsky: Many investors believe that investing in currencies is like investing in commodities: volatile. But in reality, provided you have a diversified basket of currencies, the volatility can be very low. Certainly over the last few years we've seen some strong fundamental currency trends that could potentially add value to a portfolio.
Moore: Considering the equity-dominated composition of most institutional investor portfolios (and retail portfolios as well), currencies may offer important diversification benefits "â?? so a little volatility from this segment may not be such a bad thing. Data on typical U.S. investor asset allocations shows that there is a natural home currency bias for many investors, much more so in fixed income than in equities. The increase in global equity diversification has occurred over the last 20 or 25 years, and having some currency exposure in the portfolio actually adds to the diversification benefits in the portfolio.
Q: Looking back at the surge in credit in 2009, have the best credit opportunities now passed? What are some suggestions for investing in credit in 2010?Moore: In 2009 the quick movers in the credit markets were able to take advantage of some great opportunities. Spreads are still wide relative to historical averages, but have tightened significantly from their widest levels, so really it's now become more of a security selection market. Having access to the new issue market has been very advantageous, and looking within specific sectors has been valuable. Credit investors may find good relative value opportunities within the same issuer or within a sector or industry. Having a depth of resources in credit, understanding the fundamentals of the industry, understanding the companies, and understanding the mechanics of the individual markets and how things behave is really the key to uncovering opportunities in credit markets in 2010, and "â?? more often than not "â?? over the course of the cycle.
Liability-driven investors, in particular, realize that credit usually has a natural place in their portfolios because the liabilities are benchmarked to long credit. We've been talking with plan sponsors in long government/credit mandates about the possibility of anchoring the credit component. If you consider the quantity of long Treasuries likely to come to market over the next five years and given the government's funding issues, the balance in a long government/credit index is likely to tilt more toward government. If investors consider their neutral position in long government/credit to be 50/50, they should build that into their benchmarks; otherwise they may drift along with the index toward an increase in government debt.
Q: How should investors include cash management in their allocations, given concerns about safety and liquidity?Taborsky: Many investors remain concerned about liquidity, especially after the crisis when it came to light that some cash investments remained sound while other so-called cash investments lost value. So investors are much more sensitive to the different definitions of cash investing, and the risks involved. Going forward investors may plan out their cash needs more "â?? especially longer-term investors with uncalled commitments.
For many investors, cash management could be an important component of broader liquidity management within portfolios, and it involves a solid understanding of precisely what kind of cash investment they hold "â?? whether a minimum-risk money market investment or enhanced cash that could potentially lose value.
Q: Many investors are focused on the inflation outlook and inflation protection "â?? how does a solutions-focused approach address inflation?Taborsky: In a solutions approach to inflation and inflation protection, we weave together perspectives on asset allocation, macro views, tail risk hedging and alternatives, helping clients adapt and align their views with the changing market and economic environment. One overwhelming issue with regard to inflation is the uncertainty it brings to the investing equation. The uncertainty is a risk that can't be easily quantified and hedged. In looking at inflation with a solutions-oriented mindset, we directly map it to our clients' portfolios using risk factors and think about the potential inflation protection in certain assets.
Much of the inflation approach is about seeking and evaluating the assets that are likely to perform well or less poorly in inflation scenarios. It is very important to think carefully about the inflation regime "â?? whether we're in a period of rising inflation or declining inflation, and what macroeconomic factors may affect the inflation outlook. In periods of rising inflation, lots of risky assets don't do well.
Many investors prefer to have sufficient real rate factor exposure in their portfolios to counter an inflation scenario, and they look to Treasury Inflation-Protected Securities (TIPS), commodities and select real estate investments. Many are wary of equities and risk assets, however, which can perform poorly particularly in periods of very high inflation. That said, high levels of inflation tend to not last very long; the economy usually will not sustain a high inflation regime, which leads to a subsequent period of declining inflation. In that scenario, we could work with clients to selectively add risk assets to their portfolios that are likely to benefit from a decline in inflation.
Moore: It's important to remember that inflation is not one monolithic thing: It's a basket of different pieces of inflation, and investors will have differing sensitivities to those pieces. For example, investors looking to hedge the increasing costs of medical care in retirement will focus on medical costs but pay little attention to the other components of inflation. Investors saving for their children's college education will be mainly concerned about education costs. We are beginning to work with investors on thinking more broadly about how to hedge these different inflation subcomponents, tailoring solutions for individual portfolios and objectives.
Some investors are reticent about investing large amounts in TIPS (really the only broad CPI inflation hedge), in part because they are government-guaranteed securities that lack the spread component of a corporate bond or a mortgage. Commodities are an option for some parts of the inflation spectrum, but they tend to have a fair amount of volatility. We're likely to see some interesting developments in efforts to synthetically combine inflation protection with other higher yielding or higher expected return assets. Thinking about more creative and nuanced ways to create and deliver inflation products will probably be a growing trend over the next decade.
Timing is interesting, and challenging. In the near term, inflation pressures would seem to be muted, given 10% unemployment, low capacity utilization and a more or less slow and cautious housing market. Until we have the housing market not just stabilized but upturned and we lose rental units from the broad market, housing will likely continue to be a pressure muting CPI.
Looking at the near term "â?? say the next 12 to 24 months "â?? we are likely to see a muted inflation picture. Then, as Mark pointed out, inflation thinking becomes more about uncertainty. One interesting aspect of TIPS that is sometimes forgotten is that they help hedge against that uncertainty, against unexpected inflation. Expected inflation is already built into pricing of Treasuries and many fixed income securities; what TIPS hedge against is unexpectedly higher inflation realizations.
The great concern with inflation is that degree of uncertainty "â?? it really can go either down or up. Right now, the consensus opinion is likely looking at budget pressures and a hoped-for return to more normal economic output, which could potentially lead to building inflationary pressures. But first there is a lot of slack to overcome in the system.
Thank you, gentlemen.
Past performance is not a guaranteed or reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. 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. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government agency or private guarantor there is no assurance that the guarantor will meet its obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. 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 advantageous. Investing in derivatives could lose more than the amount invested. All investments contain risk and may lose value. Diversification does not ensure against loss.
This material contains the current opinions of the manager 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. Statements concerning financial market trends are based on current market conditions, which will fluctuate. 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. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626.©2010, PIMCO
Read Full Article »