BOND. ETF Investment Solutions Series. Issue. Issues Education Solutions April Your Global Investment Authority

Transcription

1 Your Global Investment Authority ETF Investment Solutions Series Issues Education Solutions April 2012 BOND PIMCO ETFs Adding Skill and Breadth to Core Bond Portfolios with PIMCO ETFs Issue The pivotal debate is not active versus passive but where discretion is being exercised in core bond portfolios Investing in ETFs has become synonymous with passive portfolio management in some circles. This is not surprising given that passive index strategies have dominated the ETF landscape, accounting for over 99% of total U.S. ETF assets under management, according to Morningstar analysts. Yet ETFs are active portfolio management tools almost by definition, due to their tradability, enhanced liquidity and intraday pricing. Many investors have been willing to pay a premium over lower priced mutual fund share classes, or in the case of institutions, separate accounts managed against the same benchmark, for the added control and flexibility of ETFs. 1 Natalie Zahradnik Senior Vice President ETF Strategist Chris Caltagirone Vice President ETF Portfolio Manager The PIMCO ETF Investment Solution Series offers insight into the challenges investors face and provides an educational framework for implementing potential solutions using PIMCO s suite of ETF investment strategies. Investors can use ETFs to implement a number of investment strategies. As a result, they have grown in popularity among a wide variety of investors PIMCO included. ETFs are often used in the overall context of active portfolio management for strategies such as tactical or strategic asset allocation against a broad market benchmark or in a core-satellite strategy. 2 To date, investors have used mostly passive index ETFs in this way, but the portfolios in which they are used have often been actively managed on either a discretionary basis or according to some type of investment process or model. Nothing inherent to the ETF vehicle requires the underlying investment strategy to be passive. The key benefits of ETFs tradability, intraday pricing and daily portfolio disclosure are no different for active or passive ETFs. Therefore, the pivotal debate surrounding ETFs is not necessarily about active versus passive management, but rather: Where is discretion being exercised in a portfolio? How skilled is the manager?

2 What is the investment process and opportunity set? Can the ETF vehicle provide efficient access to, or help in the implementation of, a specific strategy? According to the fundamental theory of active management, 3 active discretion is best placed in the hands of the most skilled investor and best implemented where the investment opportunity set is maximized or in other words, where there is the most breadth with which skilled discretion can be exercised. Core fixed income portfolios may be particularly fertile ground for active management because they offer significant investment breadth due to the wide range of asset classes they can invest in (U.S. Treasury bonds, corporate credit, mortgages, etc.) and the high level of skill required to accurately forecast returns in each asset class. Education Do active ETFs really work? The fundamental theory of active portfolio management states that there are two potential sources of risk-adjusted excess return (as measured by information ratios, or the excess return of a portfolio over its benchmark divided by its tracking error): Forecasting ability: A manager s skill or the correlation between forecasts and the eventual returns (a measurement called the information coefficient) Breadth: Opportunity set, or the number of times a manager can use their skill Risk-Adjusted Excess Returns = Skill in Forecasting ƒ (Breadth of Opportunity) Breadth, combined with the greater market inefficiencies, historically, of trading bonds over-the-counter rather than on a centralized public exchange, makes fixed income indexes, such as the Barclays Capital U.S. Aggregate Bond Index, difficult to replicate in passive ETFs. The table below shows the number of securities in the Barclays Capital U.S. Aggregate Index compared to that in three popular broad market equity indexes: the Dow Jones U.S. Index, the S&P 500 and the Russell 3000 indexes. The table also includes the percentage of securities in the benchmark that leading ETF providers hold, along with the range of annualized tracking error and Active Share, 4 which is the percentage of securities in a portfolio that differ either in type or weighting from the benchmark. What this table illustrates is that even passive ETFs that aim to track a broad bond benchmark typically exercise a great deal of discretion, much more discretion than their equity counter parts due to the inability to fully replicate the index. COMPARISON OF FIXED INCOME AND EQUITY INDEXES AND THE ETFS THAT TRACK THEM 5 INDEX INDEX TYPE NUMBER OF SECURITIES IN THE INDEX PERCENTAGE OF INDEX SECURITIES IN ETFS OF LEADING PROVIDERS HISTORICAL ANNUALIZED TRACKING ERROR OF ETFS OF LEADING PROVIDERS ACTIVE SHARE OF ETFS OF LEADING PROVIDERS Barclays Capital U.S. Aggregate Bond Index Broad Bond 7, % bps 25-37% Dow Jones U.S. Index Broad Equity 1, % 15-20bps 0% S&P 500 Index Broad Equity % 5-20bps 0% Russell 3000 Index Broad Equity 2, % 5-10bps 0% Source: PIMCO, based on publicly available information, as of 30 December 2011 Investment Products Not FDIC Insured May Lose Value Not Bank Guaranteed 2 APRIL 2012 ETF INVESTMENT SOLUTIONS SERIES

3 For most types of active portfolio management, utilizing a broad market index ETF that is market-capitalization weighted, such as those aimed to track the Barclays Aggregate, for fixed income allocations may not be the best approach. These indexes and the ETFs that aim to track them tend to favor allocations to the most indebted segments or borrowers in the market, rather than those with the strongest balance sheets. For example, in the Barclays U.S. Aggregate Index, the relative weightings of Treasuries, mortgages and credit bonds have fluctuated dramatically from , and the largest sector by market capitalization has seldom been the highest performing in any given year as shown in Figure 1. Figure 1: Sector weights of Barclays U.S. Aggregate Index 50 Treasury Mortgages and ABS 45 Agency Highest Performing Sector 40 Credit Source: Barclays Capital, as of 30 December 2011 Percent of index (market value) Sector allocation can potentially be a significant source of excess return for active management. Estimates and actual outcomes have ranged widely, but typically sector allocation strategies can outperform on par with duration or yield curve strategies. Skilled bottom-up security selection may add even more to potential outperformance. For example, a 2006 study, Quantitative Management of Bond Portfolios, took a narrower theoretical view and focused on the potential outperformance of security selection, sector allocation and targeted duration management strategies in credit bond portfolios. It found that security selection provided the greatest return for a given level of skill and constant level of risk (defined as tracking error or the standard deviation of excess returns), followed by sector allocation and duration strategies. 6 This is a direct result of the greater breadth or opportunity set inherent in security selection and sector allocation strategies; there are more choices to be made than simply under- or overweighting duration. The greater frequency with which active decisions are reviewed and implemented for example, daily rather than monthly, or monthly rather than quarterly also creates greater breadth as does refining sector allocation decisions by credit quality and duration. The results of this study are theoretical and depend in part on how the opportunity sets are defined. However, in actual core bond portfolios, security selection and sector allocation remain significant, but the sources of alpha, or returns above the benchmark, are usually more evenly divided among security selection, sector allocation and more refined overall yield curve management. Figure 2: Value of security selection, asset allocation, and duration management assuming same constant risk 250 Sector by duration and credit quality bucket Duration 200 Sector - one overall Security selection 150 (5% of index) Mean outperformance (bp/year) % 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Skill Level Source: Quantitative Bond Portfolio Management, 2006 In the aforementioned study, skill is simulated simply by the probability of making the right investment choice (0% skill is purely random choice and 100% skill is perfect insight). What contributes to skill in real life and how is it maximized? If skill ETF INVESTMENT SOLUTIONS SERIES APRIL

4 is the ability to accurately forecast investment outcomes, then experience, resources and technology when properly applied have the potential to enhance skill. When it comes to risk, active management does not necessarily imply higher levels of risk or volatility of returns. Considerable confusion exists around this point, often because active risk is measured versus the benchmark, suggesting that by definition active strategies are riskier. However, at the portfolio level, the index, or market beta, itself drives the greater portion of volatility or intrinsic risk. For example, for Morningstar s Intermediate-Term Bond Fund category overall risk, as determined by historical realized volatility, has been lower than the index on average over the last decade, including most of the last three years as the Figure 3 shows. Figure 3: Historical 90-day realized volatility (annualized) Percent (%) Mar 01 Morningstar Intermediate-Term Bond Category Barclays Capital U.S. Aggregate Index Mar 03 Mar 05 Mar 07 Mar 09 Mar 11 Source: PIMCO and Barclays Capital as of 31 December 2011 Access to skilled active management in the ETF format provides a unique value proposition for investors, particularly when it comes to broad market allocations in fixed income, where all the levers of potential outperformance and risk management security selection, sector allocation and yield curve positioning are available to the portfolio manager. Do active ETFs really work? The question suggests that particular attributes of the ETF vehicle, namely its tradability and transparency, could curtail the portfolio manager s ability to generate returns above the benchmark. This question often arises as a result of misunderstandings about what generates superior risk-adjusted excess returns in an investment strategy skill and breadth and about specific attributes of the ETF vehicle, such as the ability to take short positions in ETFs, like stocks, or the requirement to disclose portfolio holdings on the day following trading (on a T+1 basis). Shorting an ETF does not directly impact the underlying investment strategy, and more frequent portfolio holdings disclosure is not equivalent to providing actual portfolio strategies or internal investment forecasts. ETF holdings are disclosed post-trade, not on a pre-trade or real-time basis. Portfolio managers trade securities for many reasons: investing new flows into the fund, rebalancing, gradually filling a position over time or implementing a new investment theme. Inferring the motivations for trades from the portfolio holdings would be extremely difficult. Furthermore, given the importance of breadth to active management and the over-the-counter nature of fixed income securities trading, not all market participants will have access to the same opportunity set to anticipate or replicate the fund s trades. Passive and active ETFs can be utilized together in core-satellite or other portfolio strategies. Active and passive ETFs have the same attributes: intraday pricing, the ability to be traded using limit and stop loss orders as well as on margin, daily portfolio disclosures and low investment minimums (typically one share). As a result, through ETFs, investors may be able to manage their portfolios more directly, potentially achieving greater diversification, better risk control and increased ability to tailor portfolios to specific investment objectives. The features of the ETF vehicle have made this possible not the underlying passive strategies. 4 APRIL 2012 ETF INVESTMENT SOLUTIONS SERIES

5 A PIMCO Solution How PIMCO looks to add skill and breadth to core bond portfolio management Active is the next evolution in ETFs. By utilizing active ETFs for core fixed income holdings, such as PIMCO s Total Return ETF (ticker: BOND), investors can leverage PIMCO s investment process within their own overall portfolio management strategy, and tap an additional source of skill and breadth beyond what is currently available via ETFs. Investors can have access to PIMCO s time-tested investment approach. Our investment process begins with our secular and cyclical forums. At the annual secular forum, we establish the three- to five-year global macro forecast that underpins PIMCO s long-range investment outlook. The cyclical forums occur three times a year and focus on the near term (six to 12 months) global economic outlook, including GDP and inflation forecasts. PIMCO s nearly 600 investment professionals from 12 offices across the globe participate in these forums, along with outside participants selected for their contributions to thought leadership and policymaking. Alan Greenspan, former chairman of the Federal Reserve, Gordon Brown, former British prime minister and Kenneth Rogoff, professor of public policy and economics at Harvard, have been recent forum guests. PIMCO s global investment committee uses the top-down forecasts from the secular and cyclical forums, along with bottom-up individual security valuation, to construct portfolios consistent with the unique investment guidelines of each fund. In the case of BOND, the investment guidelines closely mirror those of the existing Total Return strategy, except that no options, futures or swaps can be used in the ETF due to regulatory requirements. PIMCO s investment committee meets on average four days a week to review these investment strategies, thereby seeking to maximize the breadth with which skilled discretion can be applied to portfolio construction. At PIMCO, risk measurement and management is an integral part of the portfolio construction process. We measure individual security level risks separately and decompose them into risk factors rather than merely utilizing popular portfolio level metrics, such as Value at Risk (VAR) or tracking error. Our team of more than 40 credit analysts globally evaluate individual security credit risk, independent of ratings from the credit agencies, such as Standard & Poor s and Moody s Investors Service. We use our risk factor and credit analysis in the portfolio management process for both active and passive ETFs. Furthermore, PIMCO s global trading platform and multiple trading relationships help foster a disciplined trading approach that aims to benefit both our active and passive ETFs. PIMCO s experience in managing core bond portfolios for more than 40 years points to the depth of its forecasting skill and the breadth of its investment process. The Total Return strategy in the form of BOND is designed to allow investors to leverage the laws of active portfolio management: in essence, investors can have PIMCO join their active management team, thereby allocating increased discretion to a skilled portfolio management team with a broad investment opportunity set. Forums Portfolio Portfolio Managers Investment Committee ETF INVESTMENT SOLUTIONS SERIES APRIL

6 Footnotes 1 ETFs both passive and active typically charge less than retail share classes of comparable mutual funds, but are usually priced at a premium to institutional share classes due to their tradability and transparency. 2 The core-satellite approach to portfolio management uses index funds as the core of the portfolio, with selected active investments as the satellites. 3 Grinold, Richard C. and Ronald N. Kahn. Active Portfolio Management: A quantitative Approach for Producing Superior Returns and Controlling Risk, (New York: McGraw-Hill, 2000). 4 Active share is a measure of the percentage of securities holdings in a portfolio that differ from its index. It is calculated as the sum of the absolute value of the differences of the weight of each holding in a portfolio versus the weight of each holding in the index divided by two. 5 The methodology for compiling the data shown in the chart was to record the actual issues held by four leading index benchmarks, both broad bond and equity, and compare these to at least three leading ETF provider s (by overall ETF assets under management) funds that utilize the indexes as benchmarks. The range of the percentage of index securities held, tracking error and Active Share held by these ETFs as of the date provided is presented. All information for calculating the figures shown were obtained from publicly available information found on the ETF providers websites. 6 Dynkin, Lev, Anthony Gould, Jay Hyman, Vadim Konstantinovsky and Bruce Phelps. Quantitative Management of Bond Portfolios, (Princeton University Press, 2006). 6 APRIL 2012 ETF INVESTMENT SOLUTIONS SERIES

7 For more information, please contact your advisor, call ETF ( ) or visit 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. Effective April 4, 2012, PIMCO changed the ticker for the Total Return ETF from TRXT to BOND. No action is required for current investors in the Fund. While BOND is managed utilizing PIMCO s Total Return strategy, it does not use options, futures or swaps. 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. A word about risk: Past performance is not a guarantee or reliable indicator of future results. 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. 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. 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. 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. 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. The value of most bond funds and fixed income securities are impacted by changes in interest rates. Bonds and bond funds with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise. Duration is the measure of a bond s price sensitivity to interest rates and is expressed in years. Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Dow Jones U.S. Index is a capitalization-weighted index designed to represent 95% Of the U.S. market. Component companies are adjusted for available float and must meet objective criteria for inclusion in the index. Reconstitution is quarterly. The Russell 3000 Index is an unmanaged index generally representative of the U.S. market for large domestic stocks as determined by total market capitalization, which represents approximately 98% of the investable U.S. equity market. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index. 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. 2012, PIMCO. PIMCO advised funds are distributed by PIMCO Investments LLC. Newport Beach Headquarters 840 Newport Center Drive Newport Beach, CA Amsterdam Hong Kong London Milan Munich New York Singapore Sydney Tokyo Toronto Zurich pimcoetfs.com ETF