Q: Fundamental indexation challenged basic tenets of finance. How and why did you develop it?
A: I’d long thought that traditional indexation, which weights stocks in proportion to their popularity and price, made no sense. But in the early 2000s, following the dramatic tech-driven decline in stock index levels worldwide, a friend and long-time pension executive said, “There’s got to be a better way to index.” That led me to push this idea to the front burner. To my astonishment, the first test we ran, which weighted companies by sales, not market capitalisation, produced a 2.5% excess return compounded annually for over 30 years.

Q: PIMCO’s Fundamental Index StocksPLUS Strategies use an enhanced version of the RAFI. How do they differ?
A: The standard versions gauge a company’s economic footprint on publicly available financial data, including sales, cash flow, book value and dividends. Each helps define the relative size of a particular company and determine the corresponding weights in the index. The enhanced versions incorporate additional factors such as net operating assets (an indication of the aggressiveness of a company’s accounting), debt coverage ratios and buybacks. We also have features with Enhanced RAFI that spread the active weights more efficiently and rebalance with an eye toward lowering market impact and avoiding “falling knives.” The goal is a RAFI that’s a little higher quality and offers a modest improvement to long-term annualised return potential.

Q: Launched in 2005, the first PIMCO Fundamental Index StocksPLUS Strategy provides exposure to the U.S. large company Enhanced RAFI. Subsequent versions target emerging markets (EM), and global equities. What’s similar or different about these?
A: The methodology is the same. Differences are largely geographic. It’s also been our experience that the alpha potential is even greater in less efficient marketplaces. So, for example, the EM version has a higher excess return potential than the U.S. large company version. For PIMCO’s clients, what’s important is that there’s a reasonably complete tool kit to help improve return potential within their global, and EM and U.S. large equity allocations.

Q: How do Enhanced RAFI respond to differing market environments? What are the primary sources of value added?
A: Enhanced RAFI have a pronounced value tilt relative to the cap-weighted market, although the way I think about it is that the market has a growth tilt relative to the economy, favouring companies with wonderful growth outlooks and shunning companies that look like they are facing challenges. Enhanced RAFI tend to do better in weak equity markets, which can be particularly savage to companies trading at the highest valuation multiples. In contrast, we tend to do less well during momentum-driven equity markets that are chasing and rewarding every growth story. The value tilt is profitable more often than not. But it’s not the primary source of incremental return. Rather, what tends to be both more profitable over long periods and more reliable as a source of incremental return is contra-trading against the market’s most extravagant bets - which are those most likely to be wrong - and getting back to an index that mirrors the look and composition of the macro economy.

Q: PIMCO’s Fundamental Index StocksPLUS Strategies are an uncommon way to gain equity market exposure. Yet the identical PIMCO strategies have placed among the top in their respective equity peer groups in the United States. What is the primary value proposition?
A: Actually, there are multiple value propositions. First, there’s the portable alpha approach PIMCO helped to pioneer in the mid 1980s, which combines derivatives-based equity market exposure with an independent source of potential extra return - a PIMCO bond portfolio. Fundamental Index StocksPLUS is designed to add an additional layer of alpha by gaining exposure to the Enhanced RAFI indexes via swaps. Relative to cap-weighted indexes, this provides multiple independent sources of potential excess return: the return of the absolute return bond portfolio relative to the money market rate plus the alpha of the Enhanced RAFI. In my view, the multiple layers of diversified incremental return potential really set the Fundamental Index StocksPLUS strategies apart.

Q: How would you categorise these strategies? What bucket are they in - equities, bonds, something else?
A: It strikes me as genuinely bizarre to categorise the Fundamental Index StocksPLUS strategies as anything but equity strategies. Well over 90% of the risk comes from equity with the swap into the Enhanced RAFI. Sure, they use a bond foundation to manage the collateral, but it’s done with an emphasis on bond alpha, not systematic bond beta. The objective of outperforming the equity market with equity-market-like risk is also clearly that of an equity strategy.

Q: Any additional points?
A: In my view, the Fundamental Index StocksPLUS Strategies are a unique and elegant means to seek to capitalise on structural sources of return and diversification to deliver potentially powerful equity market outperformance. And looking forward, there is reason to believe that both components can potentially deliver attractive value to investors.

On the bond side, PIMCO has flexible guidelines for managing the fixed income component versus a money market interest rate, including an allowable duration range of −3 to +8 years. As a result, PIMCO can potentially add value even in a rising rate environment. On the Enhanced RAFI side, we have seen over the past seven years that volatile markets create opportunities for profitable contra-trading across sectors, countries and individual stocks.

Does anybody think we’re going to see less volatility in the years ahead? Not me. Further, the results are all the more impressive given the headwinds value-tilted strategies have faced over the past seven years. If value takes over market leadership in the years ahead, we might see an even more fruitful backdrop for the Enhanced RAFI approach.