Alternatives for Today's and Tomorrow's Market Challenges

• Investors should consider alternative investment strategies, which could enhance diversification and the potential for alpha, or risk-adjusted returns, because returns from traditional asset classes in coming years may be lower and more volatile than those realized historically.

• We see potential in markets where large financial institutions are stepping back, including the provision of residential credit, commercial credit and corporate lending, as well as in liquid, outcome-oriented fixed income and equity strategies such as absolute return, market-neutral and long/short.

• To capitalize on alternative opportunities, managers need broad and deep resources, while investors must understand risk exposures, both systemic and variable, and how they will likely correlate to dominant risks in their existing portfolios.

When will we see inflation – and what is the risk of deflation? How will asset classes be affected by shifts in the global economy over the next few years? With so many unknowns ahead, some answers are hard to come by. But the good news is that there are attractive ways to diversify and potentially increase sources of investment returns in the prospective environment.

In the following interview, PIMCO managing directors and product managers Sabrina Callin, who focuses on liquid alternative mutual funds in the U.S. which provide daily liquidity, and Jennifer Bridwell, who oversees alternatives structured as hedge fund and private equity strategies, discuss the outlook and potential of alternative investments for the coming three to five years.

Q: Why should investors consider alternative approaches over the secular horizon?

Callin: We expect returns from traditional asset classes will be lower than most investors have realized historically, based on underlying economic fundamentals and the level of interest rates. At the same time, we expect increased volatility – as we saw in recent months – because there is so much uncertainty. So we believe it’s more important than ever to consider new approaches, different investment strategies and, in particular, investment allocations that may provide valuable diversification and the potential for attractive alpha, or risk-adjusted returns.

Bridwell: Investors will have new opportunities to seek attractive returns as credit provision increasingly moves from banks to private capital. Lending is undergoing unprecedented reregulation because regulators want banks to reduce balance sheet risk and leverage. Regulators are erecting historic barriers to various forms of lending, especially mortgage lending, post crisis, even for banks in good and improving health. The important point for non-bank investors is simply that more return potential is available, and should continue to be available, for many years.

Q: What is the primary value proposition of alternatives for investors?

Callin: Alternatives incorporate different sources of return and risk than those provided by traditional stock and bond strategies. They may also capitalize to a greater degree on the manager’s investment experience and skill in risk management because they allow managers much greater discretion to select and manage exposures over time, and they may access less traditional sources of risk that may require specific knowledge and skill sets.

Bridwell: Most alternative strategies benefit by being free from the constraints of conventional benchmarks and having the flexibility to diversify across asset classes and geographies on either the long or short side, and by being agnostic to credit ratings. Giving the manager these types of tools to seek returns in this environment is a possible first step in seeking higher risk-adjusted returns. Sacrificing as much liquidity as you can is another critical tool in this environment, provided that the vehicle itself is not affected by from liquidity provision.

Q: Why are liquidity premiums so high?

Bridwell: Liquidity premiums are high because bank balance sheets are downsizing, and because Dodd-Frank regulation under the Volcker Rule has virtually eliminated proprietary trading, which historically had provided so much liquidity to capital markets. Banks are deleveraging by raising capital and selling credit-intensive assets. This has driven the relative yield compensation for sacrificing liquidity to higher levels than we have seen in 30 or 40 years. Of course, maintaining daily liquidity in some portion of a portfolio is important for many investors. But it’s unlikely that most portfolios need 100% daily liquidity.

Callin: Liquidity is important, particularly in the current market environment. However, so is return for investors who still need to achieve relatively high return targets. For a long-term investor, a portfolio that consists exclusively of highly liquid investments is akin to having a home country bias. You’re not going to achieve the true diversification and return that you would otherwise have the potential to achieve.

Q: Considering PIMCO’s secular outlook of muted global growth, what alternative approaches can investors take both today and over the long term?

Bridwell: We often say, “Do what the banks won’t do.” We see huge opportunities in the spaces that are most dislocated, where the large financial institution balance sheets are exiting. These include residential credit, commercial credit and segments of corporate lending.

Investors considering opportunistic strategies often ask, “Isn’t it over?” They understand the significant volume of poorly underwritten assets produced in 2006 and 2007, but they also see aggressive central bank and political measures that have stabilized markets and improved select fundamentals like U.S. housing prices. But even though banks are working through their problem assets, their propensity to lend won’t be going up – because of Basel III, Dodd-Frank and other enormous regulatory changes. The Volcker Rule, as mentioned, also has prompted the withdrawal of proprietary trading by big banks. So private capital is stepping in to fill some of the void. We think this is a very attractive space that isn’t going away soon. In the simplest terms, there will be more return potential for those willing to selectively sacrifice some liquidity.

Callin: There is an increasing variety of potentially attractive opportunities and strategies available in vehicles that offer investors daily liquidity as well. These include a number of higher alpha potential, outcome-oriented approaches like absolute return fixed income, multi-asset strategies, market-neutral equity and long/short equity. There are also currency, managed futures and bear market strategies that can provide valuable diversification and flexibility within an overall portfolio. And there are commodity and other real asset strategies that capture attractive alternative sources of market risk. Investors should traverse each of these strategies carefully as each has its own unique risk-reward characteristics.

Q: What attributes should investors look for in choosing an alternatives manager?

Callin: To truly capitalize on some of the most attractive opportunities, extensive resources are required. It’s important to have managers with exceptional and demonstrated skill, deep research capabilities, well-defined and time-tested investment processes, a global presence and a clear understanding of the underlying risk exposures. The ready ability to adjust risk exposures dynamically over time in response to varying market conditions and to know how these risk exposures may behave in stressed market environments is critical. And having a proper alignment of interests, of course, also is imperative.

Bridwell: Managers must have a large portfolio management presence in the markets in question. If you are looking to participate in bank deleveraging, for instance, you need to have relationships with the largest global financial institutions across the U.S. and Europe. That’s predominantly where legacy assets are coming from. You also need portfolio management resources in those areas to perform intensive on-the-ground work – from evaluating assets to assessing legal and jurisdictional risks. A track record of skillful navigation of the areas in question is key. Lastly, an alignment of incentives, achieved when managers invest in the strategies they run, provides an important show of confidence for investors.

Q: How can investors implement alternatives in their portfolios?

Bridwell: Hedge funds and other alternative strategies can be employed to help investors limit risk or volatility and preserve returns in their portfolios, while private equity strategies can offer a significant opportunistic liquidity premium. As we have said, though, strategy and manager due diligence is very important and has been ramped up significantly by clients globally, much to the benefit of investors, we would argue.

Callin: Alternative strategies are quite heterogeneous. There are a wide variety of approaches, risk exposures and target returns and risk. The key to realizing the important diversification benefit that alternatives offer is understanding the risk exposures, both systematic and variable, and how they will likely correlate to the dominant risk exposures in one’s existing portfolio, especially during periods of stress.

All investments contain risk and may lose value. Absolute return portfolios may not fully participate in strong positive market rallies. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Real assets generally refer to asset classes tied to adjustments in inflation such as commodities, inflation-adjusted securities and real estate.. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2013, PIMCO.