March Madness: It s Time to Rethink the Short-Term Approach to Market Upsets

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1 Featured Solution March 2014 Your Global Investment Authority March Madness: It s Time to Rethink the Short-Term Approach to Market Upsets Jerome M. Schneider Managing Director Head of Short-Term and Funding Desk Mr. Schneider is a managing director in the Newport Beach office and head of the short-term and funding desk. Prior to joining PIMCO in 2008, Mr. Schneider was a senior managing director with Bear Stearns. There he most recently specialized in credit and mortgage-related funding transactions and helped develop one of the first "repo" conduit financing companies. Additionally, during his tenure at Bear Stearns he held various positions on the municipal and fixed income derivatives trading desks. He has 18 years of investment experience and holds an undergraduate degree in economics and international relations from the University of Pennsylvania and an MBA from the Stern School of Business at New York University. Every year when I sit down to fill out my NCAA Tournament bracket, I m confronted with the same inevitable questions: Will this be the year that a #16 seed finally beats a #1 seed? Which of the favorites will stumble first? Who will emerge as this year s Cinderella story? As a testament to the chaos surrounding March Madness, for the first time, Warren Buffet has offered $1 billion to the individual who is able to choose a perfect bracket, as the odds of such an outcome are around nine quintillion to one. What we do know is, by the end of a March Madness marked by buzzer beaters, upsets and all manner of heartbreak, a single team will emerge as champion. Similarly for markets, this March has been a period of madness, of sorts. With geopolitical risks emanating from Ukraine, unexpected slowing-growth headlines out of China and, of course, the Federal Open Market Committee (FOMC) press conference and unintended clarification of the meaning of considerable period, the rates markets have been shocked. Moreover, we would characterize today s marketplace, which is driven by various accommodative central bank policies and market actors around the globe, as one where the endgame is certain, but the road there is anything but calm. In the U.S., the Federal Reserve continues to wind down its quantitative easing program, and absent a significant market event, the purchases will likely end in October. With the reduction in quantitative easing, there is increased unpredictability in asset prices: While we know that the Fed will eventually raise the fed funds rate, the timing and market reactions are difficult to predict. We here at PIMCO believe

2 this will come in the second half of 2015 or later, although other market participants think differently. Lately, we see that events such as the release of employment reports or FOMC announcements may cause waves of volatility as investors recalibrate their interest rate expectations. Note that this volatility emerges not from the uncertainty of the outcome all participants agree that the Fed will eventually hike rates but rather from the evolving timeline leading to the known destination. Like March Madness participants who know only one team will remain standing, investors recognize that the policy rate will eventually be raised. However, the interim period will be filled with twists and turns. And while both seem deceptively predictable in certain stretches, we know the road to a rate hike, just like the road to the Final Four, will be more emotional, impulsive and volatile than originally expected. Picking the right offense and spreading the defense So given this uncertainty, how should investors consider their picks for their investment bracket? Mindful of the policy dynamics, we advise investors to first consider what is likely to cause the most volatility within their portfolios in reaction to reduced central bank accommodation. In the near term, we believe the primary factor will be the volatility introduced by changing interest rate expectations, or in other words, duration. In our view, a bad pick may be to simply hide from this volatility in the perceived safety of Treasuries, where the main risk and source of return is interest rate risk. MARCH 2014 FEATURED SOLUTION 2

3 FIGURE 1: DIVERSIFICATION BEYOND INTEREST RATES MAY LOWER VOLATILITY 100 Duration: 0.66 Duration: 1.92 Contribution by sector to volatility (%) MINT Barclays 1-3 Yr. Govt/Credit Index Government Related Other Non-Agency MBS Municipals Investment Grade Credit High Yield Credit Emerging Markets Covered Bonds CMBS Cash Equivalents Agency MBS ABS Note: The chart shows the holdings of PIMCO s MINT ETF versus the Barclays 1-3 Year Government Credit Index. The index has a high proportion of government-related securities and it has a longer duration than MINT, so it should be more sensitive to interest rate changes than MINT. Source: PIMCO, Barclays, as of 18 March 2014 Portfolios that do not invest across a broad range of sectors, with a focus only on government securities, may have more embedded volatility than investors anticipate. In addition, passive portfolios that closely track a stated index may also have unexpected performance volatility because indexes, with static allocations, may concentrate risks in particular sectors, as seen in Figure 1. (The figure shows MINT compared with the Barclays 1-3 Year Government Credit Index, which is not MINT s benchmark but is a proxy for short-term passive exposure). Such concentrated portfolios of U.S. Treasuries and shorter maturity notes appear to offer respite from some market volatility. However, they have drawbacks. Most importantly, their concentrated exposure means they do not enjoy the benefits of diversification that more dynamic (active) flexible funds may offer: Because the main risk is interest rate risk, their value is directly proportional to changes in interest rates. In an environment where we expect MARCH 2014 FEATURED SOLUTION 3

4 much of the volatility to arise from changing interest rate expectations, concentrated portfolios may do little to meet investors needs for capital preservation and income at the end of the day. For evidence, look no further than historical return dispersion. While investors have traditionally turned to U.S. Treasury bills to reduce duration and hide from volatility, this comes at a price: extremely limited upside (based on history, we re talking a handful of basis points). As seen in the rolling 12-month returns shown in Figure 2, actively managed, diversified short duration strategies can outperform passive indexes. These approaches strategically allocate based on a combination of current market conditions and forward-looking expectations and they may provide downside protection in a variety of markets, wherever the risk may come from. This results in relatively attractive yields and low downside volatility with meaningful upside potential. For example, the PIMCO Short-Term Fund offers attractive returns and an SEC yield of 0.72% even in today s lowyield environment. (For more on performance of Short-Term and MINT, see Table 1) TABLE 1: PERFORMANCE FOR PIMCO S SHORT-TERM AND MINT FUNDS PIMCO Short-Term Fund Returns as of 31 Dec 13 (after fees) 1 yr. 3 yr. 5 yr. 10 yr. Inception (10/7/87) Class Inst. 0.84% 1.53% 3.15% 2.78% 4.74% PIMCO Enhanced Short Maturity Exchange-Traded Fund (MINT) Returns as of 31 Dec 13 (after fees) 3 mo. 6 mo. 1 yr. 3 yr. Inception (11/16/09) MINT at NAV 0.20% 0.52% 0.72% 1.20% 1.29% MINT at market price 0.24% 0.50% 0.71% 1.19% 1.29% Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Current performance may be lower or higher than performance shown. Investment return and principal value will fluctuate, so that fund shares may be worth more or less than their original cost when sold or redeemed. For PIMCO Short-Term Fund: Performance data current to the most recent month-end are available at pimco.com/investments or by calling PIMCO. For PIMCO Enhanced Short Maturity Exchange-Traded Fund: Performance data current to the most recent month-end are available at pimcoetfs.com or by calling ETF. PIMCO Short-Term and Enhanced Short Maturity Exchange-Traded Funds expense ratios are 0.45 and 0.35%, respectively. MARCH 2014 FEATURED SOLUTION 4

5 FIGURE 2: ROLLING 12-MONTH RETURNS FOR PIMCO S MINT AND SHORT-TERM FUNDS SINCE MINT INCEPTION (NOV. 2009) Frequency MINT rolling 12 mo. performance vs. index Sharpe Ratio: Returns (%) MINT 3 mo. T-bill Frequency Short-Term Fund rolling 12 mo. performance vs. index Sharpe Ratio: Returns (%) Short-Term Fund 3 mo. T-bill Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Current performance may be lower or higher than performance shown. Investment return and principal value will fluctuate, so that Fund shares may be worth more or less than their original cost when sold or redeemed. Performance data current to the most recent month-end for PIMCO ETFs is available at or by calling ETF or for PIMCO Funds at or call (800) Source: Fund returns from PIMCO, November 2009 (inception of MINT) through 28 February Sharpe ratios from Morningstar as of 28 February 2014 MARCH 2014 FEATURED SOLUTION 5

6 Looking for the open shot: Finding upside potential by diversifying Given the current market environment, investors may prefer to deemphasize duration as a source of return and look to less volatile sources of returns instead. This duration reduction may dampen volatility as well as provide exposure to potential upside performance. In our portfolios, this means focusing on credit and structural risk premiums. Specifically, strategies that utilize a variety of asset classes, including short-dated investment grade credit, offer a compelling return profile and will likely benefit as the economy gradually improves. Not only do these assets provide a necessary shock-absorber in terms of extra carry when interest rates prove volatile, they also are self-liquidating and are projected to mature over the next two years. Hence, they would most likely have less price volatility than longer-dated securities because they would mature before central banks may begin to curtail accommodative monetary policies through increased interest rates. Although we believe short-term interest rates should remain stable, changing interest rate expectations will introduce some volatility, so we actually see substantial opportunity in being tactical with our interest rate exposure, and a short-term strategy offers the flexibility to do that. It is our belief that the market is likely to overshoot on rates in both directions, and we will continually look to implement portfolio strategies that find a smoother route to the destination by avoiding or muting the impact of interest rate volatility. The chaos of March Madness is not confined to the hardwood. We at PIMCO are hard at work fine-tuning our brackets to help investors achieve their goals despite intermittent bouts of volatility. We aim to accomplish this with a flexible investment style, robust internal analysis and strategic thinking in our portfolio construction. While we may lack the crystal ball needed to win Buffet s $1 billion prize, we believe we can help investors avoid market upsets and experience a smoother road to the final destination attractive returns, liquidity and muted volatility. The author would like to thank PIMCO product manager Brian Leach for his contribution to this article. MARCH 2014 FEATURED SOLUTION 6

7 Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the Fund s prospectus, which may be obtained by contacting your PIMCO representative. Please read the prospectus carefully before you invest. The performance figures presented reflect the total return performance for fund type or fund share classes stated. These figures reflect changes in share price, reinvestment of dividends, and capital gain distributions. All periods longer than one year are annualized. 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. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. 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. Diversification does not ensure against loss. Exchange Traded Funds ("ETF") are afforded certain exemptions from the Investment Company Act. The exemptions allow, among other things, for individual shares to trade on the secondary market. Individual shares cannot be directly purchased from or redeemed by the fund. Purchases and redemptions directly with ETFs are only accomplished through creation unit aggregations or "baskets" of shares. Investment policies, management fees and other information can be found in the individual ETF s prospectus. 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. Foreign (non-u.s.) fixed income securities will settle in accordance with the normal rules of settlement in the applicable foreign (non-u.s.) market. Foreign holidays that may impact a foreign market may extend the period of time between the date of receipt of a redemption order and the redemption settlement date. Please see the Funds Statement of Additional Information at Premiums (when market price is above NAV) or discounts (when market price is below NAV) reflect the differences (expressed as a percentage) between the NAV and the Market Price of the Fund on a given day, generally at the time the NAV is calculated. A discount or premium could be significant. Data in chart format displaying the frequency distribution of discounts and premiums of the Market Price against the NAV can be found on the Premium/Discount tab for each Fund at The NAV of the Fund s shares is determined by dividing the total value of the Fund s portfolio investments and other assets, less any liabilities, by the total number of shares outstanding. Fund shares are valued as of the close of regular trading (normally 4:00 p.m., Eastern time) (the NYSE Close ) on each business day. The price used to calculate market returns ( Market Price ) of the Fund generally is determined using the midpoint between the highest bid and the lowest offer on the national securities exchange on which shares of the Fund will be primarily listed for trading, as of the time that the Fund s NAV is calculated. The Fund s Market Price may be at, above or below its NAV. The NAV of the Fund will fluctuate with changes in the market value of its portfolio holdings. The Market Price of the Fund will fluctuate in accordance with changes in its NAV, as well as market supply and demand. The Barclays Government/Credit Bond Index is an unmanaged, market-weighted index generally representative of intermediate and long-term government and investment grade corporate debt securities having maturities of greater than 1 year. It is not possible to invest directly in an unmanaged index. Carry is the rate of interest earned by holding the respective securities. Duration is the measure of a bond's price sensitivity to interest rates and is expressed in years. The Sharpe Ratio measures the risk-adjusted performance. The risk-free rate is subtracted from the rate of return for a portfolio and the result is divided by the standard deviation of the portfolio returns. The minimum initial investment for Institutional class shares is $1 million; however, it may be modified for certain financial intermediaries who submit trades on behalf of eligible investors. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. 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