STRATEGY SPOTLIGHT January 2018 Long/Short Equity: Diversification and Risk-Adjusted Returns in an Aging Cycle AUTHORS Amid an aging equity bull market and after four decades of steadily falling interest rates, equities and bonds alike may be facing an inflection point – and investors will need to consider all options to optimize future returns. Given the roughly 2.5% yield on the Bloomberg Barclays John M. Devir US Aggregate Bond Index today, equity returns, though Portfolio Manager unlikely to maintain current levels, may still look Long/Short Equity Strategies attractive. PIMCO expects equities to outpace other risk assets again this year. Moreover, while the S&P 500 price/earnings (P/E) ratio of 18x on 2018 earnings estimates is historically high in absolute terms, we think valuations are full but not stretched given current low Benjamin Strom interest rates and healthy earnings growth expectations. Portfolio Manager Long/Short Equity Strategies In light of these realities, we believe the time is right for investors to consider long/short equity strategies, which can play an important role in helping capture the late-cycle benefits of diversification into equities and attractive risk-adjusted performance potential. Historically, long/short equity strategies were primarily available only in the form of hedge funds and limited partnerships. Today, long/short equity strategies have migrated into more easily accessible registered investment vehicles, such as 1940 Act mutual funds. Here we share our views on opportunities in long/short equity and discuss the investment process for PIMCO’s EqS Long/Short Fund. Q: What are the potential benefits of long/short equity strategies in today’s market? A: In what could soon be the second-longest economic expansion in modern history and with markets continuing to grind higher, investors may find that allocating capital into alternative investments, such as well-designed long/short equity strategies, can offer the potential for lower volatility, capital preservation, diversification and enhanced alpha generation given the hedged nature of the product. However, investors need to tread cautiously and fully understand the unique risk profiles of such alternative investments. 2 January 2018 Strategy Spotlight These strategies can differ PIMCO EqS Long/Short Fund high and only compounded substantially, and significant has maintained a consistent stance by leverage, liquidity and losses have been realized in on equity exposure through much concentration concerns. To this various long/short funds that are of the past 18 months, with a point, the top 10 positions in the still generally correlated to the relatively low risk profile. The Fund represent only about 30% equity market. Fund’s gross and net equity of assets, compared with a 68% Looking over the past 20-plus exposures – which together concentration for the median years, the S&P 500’s compound comprise the overall risk of the long/short hedge fund in the annual growth rate (CAGR) has portfolio – averaged about 92% Morgan Stanley prime exceeded that for long/short equity and 42%, respectively, during 2017. brokerage dataset. This compares with average gross strategies. However, the long/short Core positions in the portfolio are and net equity exposures of about equity asset class (as proxied by typically in large, liquid public 232% (or 2.3 times capital) and the Credit Suisse Long/Short companies with pristine balance 70%, respectively, for long/short index) has outperformed the S&P sheets, which offers us flexibility to hedge funds (according to 500 in terms of risk-adjusted increase or decrease market Goldman Sachs prime brokerage returns (measured by Sharpe exposures as needed. We define data through 2017). While long/ ratios) and offered better downside clear catalysts and establish the short equity hedge funds do not protection, as measured by path to realizing returns from each have the constraints or maximum drawdowns (see table). investment by setting explicit price diversification requirements of targets. We strive to avoid Q: What long/short equity a ’40 Act long/short equity fund, permanent losses of capital and solution does PIMCO offer, and we think there is some level of maintain a disciplined risk how is it differentiated from comparability between the two management framework, with other approaches? products in terms of their rigorous testing of downside A: PIMCO’s EqS Long/Short Fund portfolio, management and scenarios before entering a position. risk/return characteristics. This (PMHAX/PMHIX) is a 1940 Act PIMCO EqS Long/Short Fund’s point of differentiation becomes open-end fund for retail and scalable investment process much more important in the later institutional investors that seeks to incorporates PIMCO’s vast innings of an economic expansion, offer investors access to the long- resources and tools – which in our view. term benefits of owning stocks encompass leading economic and while also preserving their capital Our focus on defending against the credit research, bottom-up during extended market declines. downside extends to avoiding financial models and industry data, Fund management focuses on portfolio concentrations (especially and portfolio management and risk sector diversification and in small- or mid-cap companies) management models that have bottom-up equity selection with an and crowded positions, and we been refined over time. We conduct emphasis on owning high quality closely monitor the portfolio’s exhaustive primary research at the businesses with strong credit correlation to equity markets and industry level, including an profiles, while maintaining strict other risk factors. We believe the assessment of secular and cyclical risk management. “cost of being wrong” is already forces, to unearth attractive relative value opportunities. And given the Long/short equity has outperformed the S&P 500 in terms of risk-adjusted returns Annualized Monthly Annualized standard Sharpe Maximum correlation Since 1 January 1994 return (%) deviation (%) ratio drawdown (%) versus S&P 500 Credit Suisse Long/Short Equity Index 8.71% 8.99% 0.69 -22.00% 0.67 S&P 500 Index 9.67% 14.42% 0.50 -50.95% N/A Source: Credit Suisse and Bloomberg as of 31 December 2017 January 2018 Strategy Spotlight 3 fund’s focus on investing in high high-profile stock blow-ups. The heavier cyclicals like machinery quality businesses, our investment Fund’s investing framework and and capital equipment, which did process includes a careful focus on owning higher-quality perform well during 2017 but tend consideration of credit quality. master limited partnerships to be more volatile and have lower- We believe that as Warren Buffet (MLPs) versus more cyclical quality balance sheets. famously said, “It’s far better to buy exploration and production Overall, we believe the Fund’s a wonderful company for a fair companies (E&Ps) with weaker performance across diversified price than a fair company at a balance sheets were critical in sectors in 2017 supports our focus wonderful price.” While it’s widely informing our positioning amid on capital preservation and reflects understood that earnings this volatility. our disciplined investment process. predictability is a solid indication Consumer discretionary. The Q: What developments are you of a high quality business, we Morgan Stanley Retail Index watching in long/short equity as believe establishing a high standard (MVRX) was up roughly 2% in we enter 2018? of quality also requires considering 2017 versus a 21% gain for the the macro and secular forces at broader discretionary sector, and A: Looking ahead, we think any work and continually “testing the our investment process, external rise in volatility or even a small moat” around the business. The data monitoring and views on correction in the market could take evolution of equity benchmarks is a secular challenges helped us seek to investors by surprise, given the testament to the reality of generate gains on the short side historically low volatility we’ve persistent economic progress and while avoiding the temptation of seen over the past 12 months and secular change: Recent Morgan buying value traps in the retail what we view as high levels of Stanley research indicates that space. At the same time, we favored investor complacency. during the last four decades, as positions in cruise lines, housing The key performance risks we’re much as 60%–65% of the companies and lodging/gaming. watching in the hedge fund in the S&P 500 changed over a given Telecom and staples. We avoided segment include a rise in gross and 10-year period. telecom companies with low- net equity exposures and Q: What are some examples of multiple and high-dividend-yield significant position concentrations, your process and active stories by sticking with our along with general investor management of the EqS Long/ fundamental process and attention crowding. We intend to strive to Short Fund in 2017? to what we view as a poor industry defend against these risks by focusing on maintaining a higher- A: The S&P 500 experienced a structure and low earnings quality, liquid portfolio with near 50-percentage-point gap in achievability. We were also prudent use of leverage at this point performance between sectors at underweight staples (which in the aging bull market. times during 2017 (at one point underperformed the market by energy was down roughly 25%, roughly 1,000 bps in 2017) due to In sum, we believe investors while technology was up over our view of challenges to organic seeking diversification, capital 25%), so staying balanced on growth and high valuations. preservation and the potential for our sector views was important Industrials. The Fund maintained enhanced alpha generation in their for performance. Here we provide a material position in rail later-cycle equity investments may examples of our process and operators, which were in our “sweet find PIMCO EqS Long/Short Fund positioning in some key industries spot” as high-barrier-to-entry to offer a credible solution.