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Evaluating PIMCO's Alternative Investment Funds

|Includes: IQ Hedge Multi-Strategy Tracker ETF (QAI), SPY

Summary

PIMCO's alternative investment funds provided excellent diversification for an equity-focused portfolio.

With the exception of REITs, PIMCO's alternative investment funds have exhibited much lower volatility than the S&P 500.

PIMCO's alternative investment funds have generally under-performed the S&P 500 on a risk-adjusted basis over the past 3 years.

In the past, traditional investments in stocks and bonds have provided investors with sufficient returns to achieve their goals. However, times have changed with bonds yields at record lows and the stock market in the later stages of a bull market. Going forward, returns from traditional investments are likely to be lower than historical averages. Realizing this, investors have been allocating more funds to alternative investment strategies.

The term alternative investment does not have a strict definition but is generally used to describe assets outside the three traditional classes of stocks, bonds, and cash. For example, alternatives could include futures, real estate, commodities, and options. The successes of some Ivy League University endowments have spurred investor interest. The Pacific Investment Management Company (PIMCO), one of the largest mutual fund providers, has also branched into these alternatives and now has over $100 billion invested in liquid alternatives. This article will evaluate a few of these funds to assess how they have fared in terms of both risk and return over several time frames. I limited my analysis to the funds that have at least a 5 year history.

PIMCO has a multitude of share classes associated with each mutual fund. I will focus on the "D" class funds, which are no-load funds that must be purchased from financial service firms, such as brokers. Each fund also has an "A" and 'C" classes that have some combinations of loads. Institutional class shares (class "I") are offered with a minimum purchase of $1 million (some brokers offer this class with a smaller minimum of $100,000).

The five PIMCO funds that I analyzed are summarized below.

PIMCO Fundamental Advantage Absolute Return Strategy D (MUTF:PFSDX). This fund seeks total return by employing a market neutral approach. Long performance is captured by using derivatives linked to the Enhanced RAFI US Stock Index. The RAFI index is based on the largest 1000 companies ranked by using multiple fundamental measures rather than market cap. The long exposure is hedge by using derivatives to establish a short position in the S&P 500. Since the S&P 500 is a market cap weighted index, this fund attempts to capture the delta between these two indexes. Only a small amount of capital is required to maintain the derivative positions and the remaining collateral is invested in an actively managed high quality bond portfolio. This fund has an expense ratio of 1.3% and yielded a very high 12.8% over the trailing 12 month period.

PIMCO All Asset All Authority D (MUTF:PAUDX) The portfolio of this fund is an actively managed collection of other PIMCO funds, including both long and short equity positions and bonds. It holds about 40 PIMCO funds over many asset classes, including alternative strategy funds. The fund has an expense ratio of 1.6% and has yielded 4.9% over the trailing 12 months.

PIMCO Global Multi-Asset D (MUTF:PGMDX). This fund also has an actively managed portfolio of other PIMCO Funds (except the All Asset, All Authority Fund and the RealRetirement Fund). The objective of this fund is to provide a comprehensive but flexible asset allocation based on PIMCO's forward looking assessment of the investment landscape. In January 2014, Mihir Worah was appointed as the lead manager of this fund after El-Erian left PIMCO. Worah is a well-respected veteran portfolio manager who has produced stellar results leading other funds so his takeover of this fund should not cause major concerns. The fund has a wide mandate and can invest across many asset classes of equities, currencies, commodities, emerging markets, and fixed income. The fund has an expense ratio of 1.6% and has yielded only 0.5% over the trailing 12 month period.

PIMCO CommodityRealReturn Strategy D (MUTF:PCRDX). This fund is now run by Mihir Worah. The fund tracks the Dow Jones-UBS Commodity Index by using a set of derivatives that do not require large cash positions to maintain. Worah invest the rest of the cash into Inflation-Protected Treasuries (OTC:TIPS). This combination of commodities and TIPs is called a "double real index strategy. The fund has an expense ratio of 1.2% and has yield less than 0.1% over the past 12 months.

PIMCO RealEstateRealReturn Strategy D (MUTF:PETDX). This fund seeks to capture the performance of the real estate investment trust (REIT) market by using a set of derivatives. This requires only a small amount of cash and the rest of the collateral case is invested in TIPs. This is another example of the "double real inflation hedge". This fund was devastated in the real estate bust of 2007 and 2008 but has been on a tear since 2009. The fund has an expense ratio of 1.1% and has yielded 5.7% over the past 12 months.

For reference, I will compare these PIMCO funds with the following two Exchange Traded Funds (ETFs).

SPDR S&P 500 (NYSEARCA:SPY). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 1.8%. SPY will be used to compare the alternative investment funds to the broad stock market.

IQ Hedge Multi-Strategy Tracker (NYSEARCA:QAI). This is the only hedge-fund-like ETF that has a 5 year history and is relatively liquid. The objective of this ETF is to replicate several hedge fund strategies including long/short, market neutral, and fixed income arbitrage. This fund has an expense ratio of 0.9% and has yielded 1.2% over the past 12 months.

To compare the performances of the PIMCO funds with each other and the reference ETFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the funds over the past 5 years (July, 2009 to the present). The Smartfolio 3 program was used to generate the plot that is shown in Figure 1.

Figure 1. Risk versus reward over past 5 years.

The plot illustrates that these funds have booked a wide range of returns and volatilities since 2009. To better assess the relative performance, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY.

Some interesting observations are evident from the figure.

  1. With the exception of PETDX, these funds did deliver on the promise of a lower volatility than the S&P 500
  2. The REIT fund had the best risk-adjusted return indicating that the high return did indeed compensate for the high volatility.
  3. The market neutral and all-assets funds had the lowest volatility but also had the smallest return. However, the risk-adjusted return associated with these funds was similar to the S&P 500.
  4. The hedge tracker ETF lagged in risk-adjusted performance with a performance similar to PGMDX.
  5. The worst risk-adjusted performance was booked by the commodities fund. The employment of actively managed bonds was not able to offset the overall poor performance of commodities during this period.

One of the attractions of alternative investments is the perceived diversification that you might receive. To be "diversified," you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The results are provided in the 5 year correlation matrix shown in Figure 2 and indicate that, with the exception of PGMDX, these funds do provide excellent diversification. As you might expect, the market neutral funds is almost perfectly uncorrelated with SPY. PAUDX also provides low correlation with SPY and the other funds. The only fund moderately correlated with the S&P 500 is PGMDX.

Figure 2. Correlation matrix over past 5 years

Next I wanted to assess if the performance of these funds changed significantly in more recent times so I re-ran the analysis over the past 3 years from July, 2011 to July, 2014. The results are shown in Figure 3 and what a difference a couple of years made! During this period, the S&P handily beat the alternative on a risk-adjusted basis. As before, with the exception of PETDX, the alternatives funds had lower volatility than the S&P 500 but during this period, returns were very poor. PAUDX, PFSDX, and QAI had similar performance, not too far below the "red line". PETDX again had a good absolute return but the performance did not adequately compensate for the large volatility. The other two funds, PGMDX and PCRDX, actually booked negative excess return during this period.

Figure 3. Risk versus reward over the past 3 years.

Finally I wanted to see how these funds performed over the past 12 months. The results are shown in Figure 4, with the blue line indicating the Sharpe Ratio of QAI. During this period, the S&P 500 was still the winner by a large margin. QAI also beat all the PIMCO funds. Of the PIMCO funds, PAUDX and PGMDX had the best performance. The market neutral fund did not fare well over the past 12 months with performance lagging all the funds except for the PIMCO commodity fund.

Figure 4. Risk versus reward over the past 12 months.

Bottom Line

On a risk-adjusted performance basis, I do not see any compelling reason for investing in these PIMCO funds. However, they do provide excellent diversification so PAUDX and PFSDX might prove to be a reasonable addition to an equity-focused portfolio. With the exception of the real estate fund, all these funds did offer exceptionally low volatility. The hedge tracker ETF has also performed well over the past year and should be given consideration as a means to diversify your portfolio.

Before ending this article, I would like to look at one other PIMCO fund.

PIMCO StockPLUS Absolute Return Short Strategy D (MUTF:PSSDX). This fund provides a short position in the S&P 500 so it has not performed well over the past 5 years. The short position is maintained using derivatives (futures and swaps) which do not require extensive cash outlays. The collateral cash is invested in fixed income securities so the short positions are offset somewhat by the bond returns. If you are looking for a way to hedge your portfolio using an "inverse" fund, this fund should be considered. It is almost perfectly negatively correlated with the S&P 500. In a bear market, it should perform exceptionally well. In a bull market, the bonds will make this fund a less painful choice than most other inverse funds. Since the market generally has an upward bias, this fund is not a good "buy and hold" candidate. The fund has an expense ratio of 1% and has generated a 1.7% yield over the trailing 12 month period.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.