FEATURED SOLUTION September 2017 With Inflation Set to Rise, a Fresh Look at Active TIPS Strategies
AUTHORS In recent years, many investors have become complacent about inflation risk on the back of falling commodity prices and slack in the economy. Now inflation fears have reemerged as commodity prices recover and the labor market tightens, while the Trump administration’s
Mihir Worah proposed policies – many of which are perceived to be CIO Asset Allocation inflationary – fan the flames. We at PIMCO agree that and Real Return inflation risk has risen and see potential for a transition to a higher inflation regime. With this in mind, it’s important for investors to contemplate how best to prepare their portfolios.
Real assets, including Treasury Inflation-Protected Jeremie Banet Executive Vice President Securities (TIPS), can play an important role by Portfolio Manager, Real Return aiming to mitigate the risks of higher inflation while also seeking to provide a portfolio with a key source of diversification relative to traditional stocks and bonds. Given their explicit link to inflation, TIPS are core to constructing inflation-fighting portfolios, in our view. The question becomes how investors can best harness the potential benefits of these securities. 2 September 2017 Featured Solution
Since also have a greater risk of volatility and Average annual total returns as of inception 30 June 2017 1-year 3-year 5-year 10-year (29 Jan ’97) may be less tax efficient. Nevertheless, in certain markets and in certain PIMCO Real Return Fund Inst. (NAV) 0.58% 0.25% 0.22% 4.65% 5.94% sectors, active managers can outperform passive managers. Bloomberg Barclays U.S. TIPS Index -0.63% 0.63% 0.27% 4.27% 5.38% Morningstar Inflation-Protected Bond How has PIMCO been able to generate Category1 median -0.32% -0.03% -0.14% 3.62% 4.98% excess returns? We believe much of our Morningstar Inflation-Protected Bond success has resulted from capitalizing on Category median – passive investments2 -0.60% 0.50% 0.16% 4.14% – market inefficiencies in ways that passive Morningstar Inflation-Protected Bond Category1 PRRIX percentile rank 24 34 19 3 1 managers can’t.
Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future UNDERSTANDING INEFFICIENCIES results. Current performance may be lower or higher than performance shown. Investment return and principal value IN THE TIPS MARKET will fluctuate, so that fund shares may be worth more or less than their original cost when redeemed. Performance data current to the most recent month-end is available at www.pimco.com or by calling 888.87.PIMCO. Differences in the Fund’s performance versus the index and related attribution information with respect to particular categories of The TIPS market is characterized by a securities or individual positions may be attributable, in part, to differences in the pricing methodologies used by the number of inefficiencies that present Fund and the index. potential hidden costs to passive indexers The institutional share total annual operating expenses are 0.58%. The institutional share net operating expenses ex-interest3 are 0.45%. and concurrent opportunities to add 1 US Fund Inflation-Protected Bond category, number of investments over each period: value for skillful active TIPS managers. S.I. (6); 10-year (112); 5-year (170); 3-year (199); 1-year (232). 2 Passive managers proxied by Funds defined by Morningstar as an “Index Fund” within the Morningstar US Inflation- As a result, investors in passively Protected Bond Category, number of investments over each period: S.I. (0); 10-year (6); 5-year (18); managed TIPS products may pay more in 3-year (23); 1-year (26). 3 Gross expenses reflect the accounting treatment of certain investments (e.g., reverse repurchase agreements) total execution costs than the fees their but do not reflect actual expenses paid to PIMCO. passive managers charge imply. And this potential lost wealth may be transferred ACTIVE VERSUS PASSIVE TIPS TIPS managers in 86% (88 out of 102) of to more flexible active market rolling five-year periods since When considering an allocation to TIPS, participants (including hedge funds and comparable passively managed funds the natural first step is to weigh the pros market makers), who may then profit at were introduced in December of 20031 and cons of allocating to an active versus the passive investor’s expense. Below we (see appendix). On average, investors a passive manager. Both approaches offer summarize some of the inefficiencies that would have received a 0.51% higher potential benefits, costs and risks. That may allow this to happen: return on an annualized basis over the said, we believe PIMCO’s track record of 10-year period ended 30 June 2017 if they On-the-run/off-the-run relative actively managing TIPS portfolios had invested in our active fund rather value trading demonstrates the potential value added than with the median passive manager. by pursuing an active approach – as At the same time, the Real Return Fund A TIPS index includes all TIPS, both evidenced by the PIMCO flagship Real has maintained its “pure” TIPS exposure, recently issued (on-the-run) securities Return Fund’s top-decile performance exhibiting a 0.97 correlation with the and existing (off-the-run) securities. As relative to its peer universe over the Bloomberg Barclays U.S. TIPS Index and a result, an index may hold two or more 10-year period ended 30 June 2017 demonstrating a similar volatility profile2 securities with very similar maturities: (institutional share class). since its inception in January of 1997. one that was just issued and an existing one with roughly the same time to The Real Return Fund has consistently There are, of course, many differences maturity. A purely passive manager will shown an ability to add value relative to between active and passive funds. In replicate the index and hold both issues passive managers on an after-fee basis (as general, passive funds typically have at index-specified weights. However, well as relative to its benchmark). In fact, lower fees and expenses compared with there may be a pricing advantage in the fund has achieved higher returns actively managed funds, which affects holding a higher exposure to one of the after fees relative to the median passive performance. Actively managed funds
1 Passive managers proxied by Funds defined by Morningstar as an “Index Fund” within the Morningstar US Inflation-Protected Bond Category 2 Volatility measured by standard deviation of monthly returns since inception. PIMCO Real Return (institutional) volatility since inception (29 January 1997): 6.1%; Bloomberg Barclays U.S. TIPS Index volatility since inception: 5.6% September 2017 Featured Solution 3
securities and a lower exposure to the Figure 1: Pricing dislocations between on- and off-the-run TIPS create opportunities other while still maintaining the same
Jan ‘25 TIPS (on-the-run) Jan ‘25 TIPS (off-the-run) overall duration and curve exposure 0% New 10-year
) as the index. TIPS auctioned
% -1% (
(Jan ‘25) New 10-year TIPS r n These possible mispricing scenarios
t u -2% auctioned (Jul ‘25) r e
e between on-the-run and off-the-run
v -3% ti a l TIPS create opportunities for active u -4% m
u managers to express relative value views C -5% while still maintaining the same key rate -6% and overall duration as the TIPS index -7% (see Figure 1).
rn 100 t u Index rebalancing r e 80 ss e
c 60 x When new TIPS issues are added to the e
e
v 40
ti index post-auction, or when existing a l 20 u issues drop from the index as they near m
u 0 C maturity, the composition and duration
(off-the-run versus on-the-run, bps) -20 Jan ‘15 Feb ‘15 Mar ‘15 Apr ‘15 May ‘15 Jun ‘15 Jul ‘15 Aug ‘15 Sep ‘15 Oct ‘15 Nov ‘15 Dec ‘15 of the index change. Per index rules, these changes take effect at the end of Source: Barclays as of 31 December 2015. Past performance is not a guarantee or a reliable indicator of the month and are predictable far in future results. advance. Knowing that rule-following indexers will be buying or selling certain Figure 2: Mechanical index rebalancing creates flow dynamics that can be exploited bonds at month-end, active managers may buy or sell TIPS in advance and 1.5 reverse the trade to the indexers at month-end. Thus the passive investor reasuries T 1.0 may end up buying at elevated prices or selling at depressed prices while still exactly matching the index’s 0.5 performance. This presents another potential hidden cost that passive TIPS 0.0 investors may repeatedly pay to more active participants in the market.
-0.5 Owing to this trading dynamic, TIPS have historically outperformed nominal (one week prior to month-end, %) -1.0 Treasuries (richened) in the week preceding a month-end duration extension of the index (see Figure 2). For -1.5 active investors, this recurring TIPS excess return relative to comparable nominal -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5 structural inefficiency presents an TIPS index extension/contraction (years) attractive risk-adjusted opportunity to Source: Barclays as of 30 November 2016. TIPS performance is measured relative to Treasuries, proxied by the add value relative to the passive index. Bloomberg Barclays U.S. TIPS Index relative to the Bloomberg Barclays U.S. Breakeven Inflation Linked Bonds Total Return Index (Index matches TIPS index with comparable nominal Treasury securities). Bloomberg Barclays U.S. TIPS Index is used to measure index rebalance duration changes. It is not possible to invest directly in an unmanaged index. 4 September 2017 Featured Solution
Funding and liquidation costs EXPANDING ACTIVE MANAGEMENT TO To further enhance potential returns, FURTHER ENHANCE POTENTIAL RETURN active managers who are willing to Though often overlooked, one assume more risk can utilize alternative Taking advantage of the market’s component of the TIPS market means to gain exposure, including the structural inefficiencies is not the only structure that may be particularly use of inflation swaps. Over recent way active managers can seek to enhance costly to passive indexers is the history, the inflation swap market has returns after fees in TIPS allocations. market-on-close (MOC) trade order become an efficient alternative to other Active managers of strategies focused on used by passive managers. TIPS indexes transactions for gaining exposure to returns above inflation can also use use market close prices to compute TIPS while also providing direct access various means to express top-down their index levels and daily returns, and to trading inflation. macroeconomic views and bottom-up MOC orders provide trade executions views specific to the TIPS and other that nearly always match these prices. PIMCO applies a broad set of active inflation-linked bond markets. strategies in an effort to closely track but While this benefits passive managers or consistently outperform the index, as well Top-down strategies include: Wall Street dealers by reducing their risk as maximize risk-adjusted real returns. of deviating from the client-specified • Duration positioning index, it can be costly for the TIPS • Positioning based on views of yield GOING ACTIVE investor. Knowing that passive indexers curve steepening/flattening With U.S. inflation fears likely to mount require end-of-day pricing to track the • Assessing TIPS’ relative value versus in the coming years, investors may TIPS index – which means they will nominal Treasuries, based on shifts contemplate increasing their TIPS effectively act as price-indiscriminate in inflation expectations allocations – and a key decision will be buyers or sellers at or near market close • Country rotation among inflation- how best to obtain that exposure. – active market participants will linked bond issuers Allocating to a skilled active manager typically richen/cheapen the TIPS • Limited sector rotation among high with a comprehensive set of TIPS market into the close in order to profit at quality non-government sectors strategies may enable investors to benefit the indexers’ expense. This can be a from structural inefficiencies in the significant cost to the passive investor Bottom-up strategies include: market and offer fertile ground for upon both funding and liquidating • Positioning to exploit seasonal generating after-fee alpha. TIPS positions. consumer price inflation (CPI) patterns, which present a recurring By contrast, active managers have a opportunity to capture attractive strong incentive to navigate around the risk-adjusted incremental return adverse pricing dynamics that tend to • “Inflation capture,” or managing the occur near the market close; they mix of short and long TIPS to express instead look for the best intraday an active view that CPI will print execution by continually assessing higher than the market expects liquidity within the TIPS market. In • Targeted issue selection this way, active managers may • Relative value trading based on the potentially provide more cost-efficient implied option value of receiving at TIPS exposure to their clients, even least the original principal value after factoring in management fees. upon maturity (i.e., the embedded deflation put) .1 APPENDIX Outper ormance ABOUT PIMCO . PIMCO is a leading global investment management firm, with offices in 11 . countries throughout the Americas, . Europe and Asia. Founded in 1971, PIMCO offers a wide range of innovative . strategies to help millions of investors . worldwide meet their needs. Our goal is to provide attractive returns while . maintaining a strong culture of risk