In Depth September 2015

Your Global Investment Authority

Liquid Alternatives: Considerations for Portfolio Implementation

Since the financial crisis, investors have poured nearly half a trillion dollars into liquid alternative strategies – typically mutual funds and ETFs that deploy non- Justin Blesy traditional strategies once reserved for large institutional Vice President i Product Manager investors. These vehicles offer the potential for diversification, downside risk mitigation and attractive risk-adjusted returns with the transparency and daily liquidity many investors desire. Liquid alternatives have been a democratizing force for investors, and we believe today’s market environment arguably has only made Ashish Tiwari Executive Vice President them more attractive. Product Manager Yet implementing liquid alternatives in portfolios presents a complex set of challenges as risk, return and fee profiles vary widely across strategies. In the pages that follow, we present an overview of liquid alternative strategies and considerations for their implementation in portfolios. Liquid alternatives: A search for returns and diversification PIMCO has been managing liquid alternative Typically packaged as mutual funds or ETFs, liquid alternatives investments for well over a decade and, according bring many nontraditional investment strategies once reserved to Morningstar data, is the largest manager of for large institutional investors to a broader investor base. Assets liquid alternative mutual funds in the U.S.ii in U.S. liquid alternative strategies have jumped from less than $100 billion in 2008 to more than $500 billion at the end of ii 2014, with potential for continued growth ahead. Their popularity At the same time, unstable correlations across many assets reflects the turbulence many investors endured with traditional have left investors with fewer reliable portfolio diversifiers. stock and bond portfolios in recent decades, as well as muted For example, the sharp increase in the correlation of stocks forward-looking return expectations for these asset classes. and bonds during 2013’s “Taper Tantrum” left many investors The experiences of the past two decades left many investors concerned about the ability of fixed income allocations to searching for additional sources of return and diversification. diversify their portfolio’s equity risk. They learned, often the hard way, that the majority of their These significant market drawdowns over the past 15 years portfolio’s return and risk had been driven by equities, an asset have resulted in much lower returns than investors experienced class prone to significant drawdowns. Although a traditional in the 1980s and 1990s. During those decades, a traditional 60/40 portfolio has a 60% capital allocation to equities, risk is 60/40 portfolio had an average annualized return of 13.7% driven almost entirely by equities given that equities are much over rolling five-year periods. In contrast, since 2000, investors more volatile than bonds. While this can lead to strong received on average 5.9% and forward-looking expectations performance during equity bull markets, as has been the case are even lower given today’s starting conditions (see Figure 2). in the U.S. since 2009, it can also leave portfolios exposed to As of 30 June 2015, 10-year U.S. Treasury yields of 2.4% were severe drawdowns (see Figure 1). near historical lows, and in stocks, the S&P 500 dividend yield

FIGURE 1: THE TURBULENT RIDE OF TRADITIONAL STOCK AND BOND PORTFOLIOS SINCE 1980

Other Traditional Fixed income Rolling 12-month drawdowns 60/40 portfolio Equities Traditional 60/40 portfolio 120 12 0

100 10 -5

80 8 -10 Volatility (%) 60 6 -15

40 4 -20 Percent (%) Percent

Market value (%) 20 2 -25

0 0 -30

-20 -2 -35 Capital allocation Risk allocation ‘80 ‘84 ‘88 ‘92 ‘96 ‘00 ‘04 ‘08 ‘12

Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. The traditional 60/40 portfolio is represented by 60% S&P 500 Index and 40% Barclays U.S. Aggregate Index.

2 SEPTEMBER 2015 | IN DEPTH was 2.1% with cyclically-adjusted P/E ratios near all-time highs. Fund launches and assets under management (AUM) This stands in stark contrast to the conditions that preceded on the rise the strong bull market in stocks and bonds in the 1980s and The current investment environment has made liquid 1990s, when10-year Treasuries peaked near 16%, dividend alternatives one of the fastest-growing categories in the yields approached 6% and cyclically-adjusted P/E ratios were investment world. Since 2008, the number of funds in the near all-time lows. Today’s environment of lower yields, higher U.S. has tripled to more than 700, and AUM has quintupled to valuations and slower global growth has led to modest long- $500 billion with the number of firms managing these funds term return expectations for stocks of 4.5% and for core bonds reaching nearly 300iii. However, the proliferation of strategies of 2.5%, according to PIMCO’s latest capital market projections presents its own challenges. Researching liquid alternative as of June 2015. strategies can sometimes raise more questions than answers Against this backdrop, liquid alternatives hold out the prospect for investors, including the basic question, “What is a liquid of alternative sources of return and portfolio diversification, alternative?” Additionally, short track records and broad which has in part fueled their growth. flexibility of many liquid alternative strategies make it difficult to understand underlying risk and return characteristics, complicating portfolio construction. FIGURE 2: SINCE 2000, RETURNS FROM TRADITIONAL PORTFOLIOS HAVE FALLEN, WITH PROJECTIONS FOR MUTED FORWARD-LOOKING RETURNS FIGURE 3: LIQUID ALTERNATIVES COME TO MAIN STREET

5-year rolling returns – 25th percentile PIMCO’s 10-year capital AUM Growth Traditional – 75th percentile market assumptions $600 60/40 portfolio Average 18 18 16 16 500 14 14 13.7% 12 12 400 10 10

8 8 300 Percent (%) Percent 6 (%) Percent 6 5.9% 4.5 3.7 (billions) AUM 4 4 2.5 200 2 2 0 0 1980 – 1999 2000 – 2014 U.S. Core U.S. 60/40 100 stocks bonds portfolio Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. The traditional 60/40 portfolio is represented by 60% 0 S&P 500 Index and 40% Barclays U.S. Aggregate Index. Data on right-hand chart is as of 2008 2009 2010 2011 2012 2013 2014 30 June 2015.

Currency Bear market Real estate-linked Commodity Multi-alternative Managed futures Equity market-neutral Long/short equity Nontraditional bond

Source: Morningstar, U.S. data, as of 31 December 2014

IN DEPTH | SEPTEMBER 2015 3 Defining liquid alternatives but alternative asset classes and alternative investment Amid the multitude of strategies, defining liquid alternatives strategies can be effective diversifiers for distinctly precisely isn’t simple. At PIMCO, we take a broad view: We different reasons. define liquid alternatives asinvestments that exhibit Alternative asset classes, such as commodities and emerging modest to low correlation with traditional stock and market currencies, provide exposure to alternative risk premia bond investments and are accessible in broadly available whose returns are driven by different economic drivers than investment vehicles that are without the principal traditional portfolios. Alternative investment strategies, on the lock-ups of traditional private equity funds and hedge other hand, are typically actively managed and not constrained funds. The term “liquid” therefore refers to the vehicle, not by traditional benchmarks. These strategies may provide the underlying investment (which may or may not be liquid). diversification through the manager’s individual security We further divide liquid alternatives into two major categories: selection (or active management alpha), with much less alternative asset classes and alternative investment reliance on broad stock and bond exposures to deliver returns. strategies. In both cases these investments tend to exhibit Examples of alternative strategies include absolute return fixed modest to low correlations with traditional stocks and bonds, income, equity long/short and managed futures (see Figure 4).

FIGURE 4: THE LIQUID ALTERNATIVES LANDSCAPE

Liquid Alternatives

Traditional portfolios Alternative asset classes Alternative investment strategies

Traditional stock and bond strategies Investments where primary drivers of Actively managed strategies that include a risk/return are different than long stock higher degree of manager discretion and or bond beta a broader tool kit in an effort to enhance returns and/or diversify risk

Categories Categories Active management risk • Currency • Multi-alternative Alternative risk factors • Bear market • Managed futures Stock and bond risk • Real estate-linked • Equity market-neutral • Commodity • Long/short equity • Nontraditional bond Source of risk exposure

Source: PIMCO Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

4 SEPTEMBER 2015 | IN DEPTH Liquid alternatives: Portfolio considerations In many ways, it is easier to grasp the risk profile of alternative Understanding risk characteristics asset classes, such as real estate investment trusts (REITs), commodities and currencies, since investment products in The varied risk characteristics of liquid alternatives – which these categories often share similar benchmarks. While the reflect an array of asset classes, strategies and manager styles benchmarks themselves often represent nontraditional sources – can complicate the process of incorporating them into of risk, investors have a better understanding of the risks they portfolios. Long/short equity managers, for instance, typically are taking. have a positive equity beta (they are normally net long equities), whereas equity market-neutral strategies target zero However, there is a much greater challenge across most equity beta. Other categories, such as managed futures, may alternative investment strategy categories, as risks can vary have more dynamic equity beta; equity beta may be positive in dramatically even within the same category. Many of these strong bull markets and negative during sustained market strategies are often benchmarked to cash or LIBOR, providing sell-offs. Implementing liquid alternatives in portfolios, little anchor for the risks in the underlying strategies. For therefore, requires understanding not only the different example, a review of the top 10 managers by AUM in the categories of strategies but, perhaps more importantly, nontraditional bond category reveals significant differences in comprehending how their key risk characteristics vary across total volatility and the risk contributions from credit and different market environments. duration (see Figure 5). Multiple factors can drive these discrepancies, including differences in investment processes, breadth of opportunity set, investment outlook and product structure.

FIGURE 5: RISKS ARE OFTEN IDIOSYNCRATIC

Full sample risk decomposition 6

5

4

3

2

1 Realized Volatility Realized Volatility (%)

0

-1 Nontraditional Nontraditional Nontraditional Nontraditional Nontraditional Nontraditional Nontraditional Nontraditional Nontraditional Nontraditional Bond Manager Bond Manager Bond Manager Bond Manager Bond Manager Bond Manager Bond Manager Bond Manager Bond Manager Bond Manager A B C D E F G H I J

Residual EM FX DM FX EM Sov spread HY spread IG spread U.S. MBS spread U.S. Muni spread JP duration EUR duration 10-30 slope 2-10 slope U.S. duration

Source: Bloomberg and PIMCO calculations as of 30 June 2015. Based on U.S. data. Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

IN DEPTH | SEPTEMBER 2015 5 Therefore, we believe investors contemplating adding liquid Alternative Asset Class Strategies alternatives to their portfolios should have a solid grasp of the following: Bear market strategies are structured to provide attractive beta-hedging (or outright short) exposure. n Total volatility and mix of risk, particularly correlations to Commodity and real estate-linked strategies are tied to traditional portfolio risks – equity risk and interest rate risk the performance of “real assets,” such as commodities and real estate. n Historical drawdowns and drawdown potential and how Currency strategies are designed to provide structural they compare with expectations exposure to foreign currencies, in both developed and n Level and use of leverage and options to identify potential emerging markets, based on macroeconomic views and hidden risks valuation analyses. n Performance across different market environments Alternative Investment Strategies

Equity market-neutral strategies seek to provide limited Considerations for manager selection equity beta by taking equal long and short positions, thereby Much as with traditional hedge fund and private equity fund isolating the alpha component of an equity strategy. investments, manager selection is crucial to the success of Long/short equity strategies are designed to provide a liquid alternative investment. As a manager’s discretion variable equity exposure while allowing for broader increases, so too does the potential for over (and under) management of market risk and/or the ability to benefit performance. Figure 6 shows the range of outcomes by from short exposure with improved downside risk mitigation. category over the five years ending 30 June 2015. Not Multi-alternative strategies seek attractive risk-adjusted surprisingly, more traditional investments provided relatively returns with modest volatility and limited downside potential consistent results across managers while alternative by allocating across a broad range of absolute-return- investments had a much wider band. Whether offered as oriented strategies. private or public strategies, many alternative strategies are inherently more dependent on portfolio manager expertise – Managed futures strategies seek to generate positive a larger component of returns may derive from active manager returns by capturing price trends across major asset classes decisions, not market returns. However, given short track and have historically provided diversification to a traditional portfolio of stocks and bonds, especially during times of records across many funds and the large number of options, market stress. manager selection can prove challenging. On the next page, we outline a suggested checklist for reviewing a manager’s Nontraditional bond strategies seek positive returns potential to generate attractive risk-adjusted returns. across all market environments by investing across global fixed income markets, often using a broad range of instruments; results are achieved through a combination of active management and trading expertise.

6 SEPTEMBER 2015 | IN DEPTH FIGURE 6: IN ALTERNATIVE STRATEGIES, MANAGER SKILL PLAYS A BIGGER ROLE

Return dispersion: difference in returns between 20th and 80th percentile managers by category Fixed income Equities 12 12

10 10

8 8

6 6

Return (%) 4 4

2 2

0 0 Intermediate- Nontraditional bond Fixed income Large blend Long/short equity Long/short equity term bond relative value (liquid alts) (hedge fund)

Traditional investments Liquid alternatives Hedge funds

Note: Data is for 30 June 2010 to 30 June 2015. Source: Morningstar, Eurekahedge and PIMCO calculations as of 30 June 2015. Based on U.S. data. Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

Key attributes for liquid alternative managers:

n Exceptional and proven manager experience n Trading efficiency, often achievable through economies of scale – Returns generated in a consistent and diversified manner n A robust risk management framework

– Strong performance during periods of market shocks n Proper alignment with investor incentives

n A well-defined and repeatable investment process n Ability to clearly communicate strategies, objectives and risks to investors n Depth of research and a demonstrated ability and process to convert research themes into profitable trades n Regulatory/compliance processes and experience in managing mutual funds and ETFs n Understanding of the underlying risk factors and the ability to dynamically adjust such exposures within the portfolio as warranted

IN DEPTH | SEPTEMBER 2015 7 Fee variance FIGURE 7: TOTAL FEES AND EXPENSES RANGE WIDELY Fees, of course, are another important consideration, and they Credit relative value* also vary widely across liquid alternative strategies. Part of this variance is driven by the structure of the investment product. 63 95 149 For example, some managers aggregate third-party strategies, passing through underlying fees to end investors. In contrast, other structures that focus on individual securities may offer Equity market-neutral lower fees. When investing in alternatives, higher fees may be 69 123 202 justified by the additional return potential offered – but not always. It is therefore important to evaluate a manager’s fee in relation to the value generated (see Figure 7). Long/short equity 100 150 219

Managed futures 113 165 201

Multi-strategy

65 163 239

10th Percentile Median 90th Percentile

Source: Lipper and PIMCO calculations as of 30 June 2015. Based on U.S. data. *Credit relative value is a subset of nontraditional bond. Fee structures for other investment products and jurisdictions may vary. An investor should thoroughly review offering documents prior to making an investment decision.

8 SEPTEMBER 2015 | IN DEPTH Implementing liquid alternatives Incorporating liquid alternative strategies in portfolios has the potential to expand the opportunity set and increase the chance of successful outcomes. Depending on an investor’s objectives and tolerance for risk, liquid alternative strategies can play a variety of roles in a portfolio and are commonly implemented in the following ways:

Dedicated liquid alternatives allocation FIGURE 8: DEDICATED LIQUID Dedicating a portion of total assets to liquid alternative strategies has the potential to improve ALTERNATIVES ALLOCATION risk-adjusted returns, improve diversification and address tactical market views and concerns.

Importantly, as successful as various liquid alternatives may be, their impact on an overall Cash Core portfolio depends on the size of their allocation relative to traditional stock and bond stocks allocations. Allocations as small as 5% are unlikely to significantly increase return potential or Liquid alternatives reduce downside risk. As such, investors may wish to consider increasing their overall dedicated

alternatives allocation, as many institutional investors have already done – often between Core bonds 10% and 30% and sometimes higher depending on investment objectives (see Figure 8).

Careful thought should also be given to the mix of strategies included in a dedicated liquid Source: PIMCO alternatives allocation. Ideally, strategies should complement each other and provide diversification to the overall portfolio. For example, an alternatives allocation with signficant exposure to multiple long/short equity strategies may serve to amplify, rather than diversify, a portfolio’s equity risk relative to other liquid alternative strategies. Careful analysis of the underlying strategies’ risks will help to ensure sufficient diversification.

Core complement FIGURE 9: CORE COMPLEMENT The constrained, relative-return framework of traditional long-only strategies can limit a v ernati e com alt pl portfolio manager’s ability to mitigate risk and add value. As a result, many investors are d em i e u n iq complementing their core benchmark-oriented strategies with absolute return-oriented L t approaches that allow for greater manager flexibility and a broader opportunity set relative Core to traditional approaches (see Figure 9). For example, within fixed income, investors could pair Traditional stock and bond exposure traditional benchmark-oriented core bond allocations with unconstrained allocations; within equities, they could add long/short strategies to complement long-only equity strategies. Importantly, liquid alternatives may provide an element of tactical repositioning based on current market information that is lacking from diversified but static asset allocation models. However, absolute return portfolios may not necessarily fully participate in strong, positive Source: PIMCO market rallies.

IN DEPTH | SEPTEMBER 2015 9 Contrasting liquid alternative strategies with hedge However, there are trade-offs. Not all traditional hedge fund and private equity investments fund and private equity strategies can be responsibly offered in a liquid alternatives vehicle. Many require Initially, hedge funds and private equity funds were the capital lock-ups to align the liquidity provided to clients primary way investors accessed alternative investments. with the horizon of the fund’s investments. Often, this Neither was widely available beyond institutional or embedded illiquidity premium can offer the potential for accredited individual investors, in part, because both more attractive returns than can be achieved in liquid typically required large minimum initial investments and strategies, and in a world of lower-return prospects, this lengthy lock-ups and offered little transparency. Relative higher return potential may be an attractive benefit of to these semiliquid and illiquid alternatives, liquid hedge fund and private equity strategies. alternatives may provide a number of benefits, including: It is important to note, though, that several strategy n Lower investment minimums types, including managed futures and equity long/short n Daily liquidity in most vehicles strategies, increasingly can be implemented in liquid vehicles without a significant reduction in return n Improved transparency potential, whereas private real estate, infrastructure and n For U.S. investors, simplified tax reporting private equity strategies may necessitate reduced liquidity (typically a 1099, not a K-1) to achieve investment objectives (see Figure 10).

FIGURE 10: COMPARING THE BENEFITS Liquid alternative strategies can provide many of the same advantages as private fund alternatives. They offer low correlation and the potential for higher excess returns than traditional 60/40 portfolios with the same transparency, accessibility and ease of transaction.

Traditional 60/40 Liquid (public fund) Private fund portfolio* alternatives* alternatives Potential diversification benefits vs. traditional None Moderate/high Moderate/high 60/40 portfolio Daily liquidity (most vehicles) Yes Yes No

Transparency High High Moderate

Accessibility Broad Broad Accredited investors only

Typical Tax reporting (U.S. investors) Typically 1099 Typically 1099 Typically K-1 attributes Long/short flexibility None/limited Yes Yes

Potential capture of illiquidity premium Low Low High

Potential capture of nontraditional betas Low High High

Source: PIMCO * Benefits limited to when implementing in an investment product offering the underlying characteristics. An investor should thoroughly review offering documents prior to making an investment decision.

10 SEPTEMBER 2015 | IN DEPTH Proceed with caution, but do proceed However, as discussed, investors should be aware of several key considerations before investing, notably how Over the coming years, growing numbers of investors will risk and return drivers vary significantly across liquid likely be adding liquid alternative strategies to their alternative strategies. Understanding how these factors portfolios. Amid an environment of lower yields, higher may affect a strategy’s performance across different valuations and slower global growth, liquid alternatives market environments holds the key to successfully can be an important addition to investor portfolios, incorporating liquid alternatives into investor portfolios. offering the potential to enhance returns and better manage risk. Indeed these strategies have seen tremendous growth since the financial crisis with a proliferation in the number of strategies and significant growth in assets.

IN DEPTH | SEPTEMBER 2015 11 i PIMCO’s liquid alternative strategies are without the principal lock-ups of traditional private equity funds and hedge funds and include separate accounts whose holdings can be liquidated at a client’s request subject to current market conditions, mutual funds that can be liquidated at NAV on a daily basis and ETFs that can be liquidated on the secondary market under normal market conditions. There is no guarantee that a security will be able to be liquidated in a timely fashion or when it would be most advantageous to do so. ii As of 30 June 2015, Morningstar Direct. Based on Morningstar’s alternative mutual fund categories and assets under management. iii Morningstar data as of 30 June 2015. Liquid alternatives are limited to certain investment vehicles organized in certain jurisdictions; not all investment vehicles may be available to all investors in all jurisdictions. All investments contain risk and may lose value. Alternative investment strategies are often subject to greater risk than traditional investments. Diversification does not ensure against loss. Risk Factor Modeling: PIMCO has historically used factor-based stress analyses that estimate portfolio return sensitivity to various risk factors. Essentially, portfolios are decomposed into different risk factors and shocks are applied to those factors to estimate portfolio responses. Because of limitations of these modeling techniques, we make no representation that use of these models will actually reflect future results, or that any investment actually will achieve results similar to those shown. Hypothetical or simulated performance modeling techniques have inherent limitations. These techniques do not predict future actual performance and are limited by assumptions that future market events will behave similarly to historical time periods or theoretical models. Future events very often occur to causal relationships not anticipated by such models, and it should be expected that sharp differences will often occur between the results of these models and actual investment results. Stress testing involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events. These methodologies can include, among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments. Barclays 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. 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