Q: What is the history of the fund?

When the fund was launched in early 2007, it was the only open-end fund investing strategy fund at PIMCO with the primary objective of a consistent dividend stream. Its mandate remains the same today, and we try to achieve this while preserving capital particularly during difficult market environments, and generate positive price performance when provided an opportunity. 

Q: How is the fund different from its peers?

Our global, income-oriented portfolio uses PIMCO’s top-down, macro-focused investment process. All too often among our peers, managers look to maximize yield through fairly concentrated credit risk. We use an approach that is a bit more creative, mixing higher-yielding with higher-quality assets through prudent diversification across a global opportunity set. 

Q: How do you define your investment philosophy?

We view ourselves as the conductors of an orchestra. Our job is to harness the best income ideas that are identified by a large team of portfolio managers and analysts across the globe, in a manner consistent with PIMCO’s top-down macro process. While we look to concentrate our investments in the best income ideas in various sectors, we are able to obtain diversification at a portfolio level by investing in numerous asset classes around the globe.

Flexibility is valuable to us as well. We are not tied to the fund’s benchmark, and instead use scenario analysis that leverages PIMCO’s macro process to come up with scenarios for key variables that affect financial assets, then probability-weight them to create a robust portfolio. 

There is a final point of our philosophy not explicitly stated in the fund’s objectives, something we refer to as a “bend but not break” construct. In a strategic income fund, it is critically important to protect principal during challenging market environments. To preserve capital, we look for two things: securities backed by assets with sufficient coverage – those with hard assets backing them – as well as sufficient structural seniority.

Currently, assets under management in the strategy are $67.6 billion. 

Q: What is your investment strategy and process?

PIMCO has a highly structured investment process for all portfolios to ensure they are consistent with the firm’s macro view of the world. 

Once a quarter, we go through the formal review process, where it examines our beliefs on economic growth, inflation, policy, and other technical factors impacting financial markets and comes up with its general outlook. Based on this, we set targets across key risk factors and determine ranges around them.

Relative value across credit sectors is an ongoing and daily discussion. We communicate with specialists all over the globe, and based on our high-level guidance, they show us offerings or bids for positions they think make sense with our overall asset allocation. To determine appropriate position sizing across market segments and sectors, stress tests are run with the help of the analytics team.

As part of our regular sector analysis, we consider different alternatives. For example, we may look at a liquid index of high-yield bonds, at non-government guaranteed mortgages, corporate bonds, or perhaps bank loans. 

To determine what the best portfolio would like for a given market segment, we estimate base-case returns under different economic and policy scenarios, and see what would happen on a hold-to-maturity basis should an exposure be taken to a particular sector. Evaluating the stated probability distribution of outcomes allows us to compare the likelihood for short-term and long-term performance of a sector. 

In doing so, we attempt to put all assets on a level playing field, and zero in on those with some credit exposure. 

A recent real-world example is the choice we made between high-yield corporate bonds and some pre-crisis originated mortgage-backed securities, both of which have a below investment-grade rating. Because analyzing non-agency mortgages requires big teams with a lot of data and technology, being at a large global firm gave us the resources needed to uncover attractive value in the sector. 

In nearly every scenario that was analyzed, the non-agency or legacy mortgage bond was expected to outperform. As a result, we have a significant overweight in U.S. housing-related investments and a comparatively underweight exposure to the high-yield corporate bond market.

This decision was not made because high-yield corporate bonds are a bad investment. A scenario analysis simply uncovered an asset class which we believe will do better than the alternative. 

We are structured at a high level around risk factors first and around a sector or segment of the market second. In addition to having dedicated teams, we recently added even more specialized resources: experts in legal jurisdictional matters, quantitatively focused portfolio managers, and people who are involved in more complex situations. 

Q: How do you look for opportunities as part of your research process?

Trade ideas occur literally in real time 24 hours a day as we rotate through global offices entering their trading sessions, as well as from more formal solicitations. For example, all portfolio managers must submit their three best ideas quarterly, and our specialty areas update the portfolio management team weekly. We also discuss sectors with the overall investment committee and within regional committees.

We focus on absolute return and are tactical and aggressive when being paid to go on the offense. Because the fund is not tethered to a benchmark, we can be flexible and get shareholders’ capital into areas of the market with the greatest opportunity. 

The portfolio is not a trading vehicle where things are whipped around all the time; our average portfolio typically has lower turnover than most competitor strategies. However, if we think that changes can make the portfolio better, we will make adjustments after taking transaction costs into account. 

We do our own credit work on bonds, using internal analysis and ratings instead of relying on a credit agency’s views, but do look at downgrade risks and how those could impact market technicals.

From a technical perspective, if an instrument’s rating drops from investment-grade to below investment-grade, it may then fall out of a popular benchmark, leading to forced selling pressure. 

A good strategy for us is to wait for the downgrade to occur, then step in and provide liquidity to those in the marketplace that absolutely need to sell. We did this a few years ago when Brazil government controlled energy explorer Petroleo Brasileiro SA or Petrobras was downgraded, leading to massive technical selling that took valuations to extreme levels. At that point, we stepped in and not only generated an attractive income, but also an attractive total return for our investors. 

We find sources of additional return by moving into situations that are complicated and difficult, where market technicals are unfavorable. To avoid too much uncertainty or volatility, we purchase in at an appropriate size using our own fundamental work. As things stabilize over time and the agencies upgrading their ratings, we see that bit of extra total return for our clients. 

Q: What is your portfolio construction process?

We have near complete flexibility from an asset allocation perspective, and try to use that to our advantage by being open minded, having a global opportunity set, and being as sophisticated as possible in portfolio construction. 

Individual name restrictions come from risk management. Typically, the portfolio runs below its concentration limits because we want it to be robust without too much exposure to any one theme or name. 

We think about diversification continuously in terms of optimal position sizing. Working with our analytics and risk management teams, a mix of assets with different characteristics is considered to reduce volatility and provide greater price certainty during difficult market environments. 

Because this is a flexible strategy, we never look to the fund’s benchmark, the Barclays Aggregate Bond Fund, from a portfolio construction perspective. However, we do want to outperform it in the long run to provide better risk-adjusted returns. 

Every day, a report adjusted for volatility shows us how we are doing over shorter term, medium term, and longer-term periods versus our peers. Not only can it be dangerous to become too short-sighted, but also given PIMCO’s top-down macro process, we try to assess longer-term trends and themes. 

Typically, we do not run a lot of aggressive currency positioning. Though the fund has a 10% maximum currency limit, historically it has typically been in the 2.5% to 3% range. In order to keep volatility low, the majority of our exposure to the U.S. dollar is often being hedged back. 

Even though our mandate is flexible, we always try to adhere to several key principles: capital preservation, structural seniority, hard asset coverage, sufficient global diversification, and having high-quality assets to temper volatility in difficult market environments. This tilts us toward assets with certain characteristics; we will always skeptical about buying subordinate debt, about the bank capital space, and in some higher-risk areas of emerging markets. 

In extreme periods of dislocation, we will opportunistically move into these areas, but more often than not, they are inconsistent with our objectives. 

Our world is one with high debt levels, increasing populist tendencies across many regions, political uncertainty, low growth, and asset valuations that are quite high. Because our economic environment is fragile, we are careful not to take excessive risk. 

One way we do this is by having a duration range of zero to eight years. Until recently, our duration was at approximately 2.5 years, our lowest level ever. We have added a little since then with the recent pullback in rates to around 1.77% on the 10-Year. Still, it is comfortably below 3 years and we are positioned defensively to broader interest rate exposure. 

We prefer assets that stand on their own from a credit perspective even if we have to give up a bit of yield, and constantly look for positions that will become more stable. Increasingly, we avoid positions that could be susceptible to a change in central bank policy—this drives us to sectors with more hard asset coverage.

Liquidity management is crucial to decisions on how to invest across portfolios. We want to make sure to get sufficient compensation in the form of higher yield to take more liquidity risk or uncertainty. If we do not think that will happen, we choose a more liquid alternative and run a large cash balance. 

Currently, about a quarter of our portfolio is in cash or positions that could be quickly turned into cash. Though not alarmists, we do like to have liquidity – during a period of market overshooting like with recent Brexit event, it allows us to go on the offense and is an important tool to generate return. 

Q: How do you define and manage risk?

Risk is embedded in the heart of our process. We discuss it each week with the investment committee and with our risk managers across strategies, and strongly encourage cooperation across those groups. 

We have taken the best practices from more complex areas of the market, like hedge funds and other alternative products, and try to instill their famed sense of partnership and communication between our risk management analytics and portfolio management teams.

For example, we dedicate one risk manager per strategy whose job is to understand the portfolio management team and the philosophy of its managers. What types of principles guide them? Do they exhibit tendencies or bias? Is one portfolio manager more risk-taking or risk-averse than others? What things are they consciously not doing that they could be doing? By understanding the conscious decisions made by our portfolio managers, they can better see how the portfolio is constructed to hit or exceed our return target.