Featured Solutions

Targets and Tactics: Overcoming Lower Return Expectations

As consensus grows on the prospect of lower asset class returns, investors are taking a fresh look at the potential consequences and solutions.

As consensus grows on the prospect of lower asset class returns, investors are taking a fresh look at the potential consequences and solutions.

The potential consequences are stark:

  • Public pension funds may not achieve their return targets, making it difficult to meet obligations without future budget sacrifices.
  • Corporate defined benefit pension plans relying on excess returns over the liability growth rate to shore up deficits could be on the hook for additional contributions.
  • Individual investors facing a steeper challenge in accumulating sufficient assets to live comfortably in retirement may have to lower living standards and save more.

As to potential solutions, investors could raise their expected returns by increasing allocations to riskier asset classes – but this would come with significantly higher risk and shortfall probability.

We believe a better and more efficient approach would be to replace current traditional physical equity exposures with synthetic equity exposure backed by long-duration bonds. This may enable investors to achieve increased long-term expected returns with lower incremental volatility.


According to research by Callan Associates, lower returns expected across a variety of asset classes would require investors to take significantly higher risk today to reach the same expected returns as in the past (see Figure 1).

Figure 1 features three pie charts to show how targeting a 7.5% expected investment return has gotten riskier over time. The first pie chart, on the left, indicates that an allocation in 1995 could be all in bonds to get the 7.5% return, with risk at a standard deviation of 6%. The next chart, representing 2005, shows that 48% of a portfolio must be allocated to other riskier asset classes of equity, real estate and private equity, resulting in a risk of 8.9%. By 2015, shown in a pie chart on the right, has just 12% of holdings allocated to bonds, and the rest to other asset classes, resulting in a risk of 17.2%.

Most investors would find such an increase in risk undesirable, and many have already responded by trimming return expectations to some extent.

However, we believe investors should also consider non-traditional approaches and strategies with the potential to enhance returns with lower incremental risk. Among these, strategies that combine returns from two different asset classes for the same invested dollar can potentially offer a better risk/return trade-off than a blunt shift toward riskier assets – provided that the asset classes combined have a relatively low correlation. This approach – variously known as portable alpha, double value or overlays – is simpler than it sounds.


Consider an investor with a traditional 60/40 equity-bond portfolio. In The New Neutral environment, this portfolio is expected to return about 4.0% annualized over the next 10 years, based on PIMCO’s capital market assumptions. If our investor seeks to compensate for lower return expectations with a riskier asset allocation, she could boost her return expectation by 50 basis points (bps), to 4.5%, by drastically shifting the portfolio to 90% equity/10% fixed income. However, as shown in Figure 2, this would increase her risk exposure by a whopping 50% (with return volatility jumping from 10.1% to 15%). As such, simple asset allocation shifts toward riskier asset classes are unlikely to be an attractive solution.

Figure 2 is a table showing two different portfolio allocations: a 60/40 equity/fixed income setup, and 90/10 configuration. Data as of 30 June 2016 for estimated return, volatility and estimated return per unit of risk are included within. Bottom line, by going to a 90/10 portfolio, potential return only rises 50 basis points, yet volatility increases by 4.9 percentage points, resulting in a lower expected return per unit of risk of 0.1.

Let’s now postulate that our investor maintains her equity exposure at 60% of assets. The equity exposure, though, is achieved through the use of an overlay (equity index futures or swaps), which requires only a small capital commitment. The assets that had formerly been deployed in the traditional equity portfolio made up of physical stocks now become available for investment in a portfolio that will serve as collateral for a synthetic equity exposure. Under the right conditions, these assets could be put to work in an effort to enhance the equity overlay returns.

The collateral portfolio should have these attributes:

  1. Relatively low correlation to equities
  2. High probability of outperforming the equity overlay financing rate (i.e., earning a return meaningfully above Libor)

If these conditions are met, the risk/return trade-off could be significantly better than the traditional re-risking approach shown in Figure 2.

Given their historically low correlation to equities and outperformance potential relative to the financing rate, long-duration bonds could represent a good choice for the collateral portfolio investment (see Figure 3).

Figure 3 is a line graph showing the five-year rolling correlation of long bonds versus global equities over the time period 2000 to mid-2016. In 2016, the correlation is about negative 0.2, and has been negative since mid-2012. In 2000, the correlation is 0.2, then declines to about negative 0.1 by mid-2001. Over most of the 2000s it’s close to zero or slightly negative. In 2007, it shoots upward to a high of 0.4, and then starts a gradual downward trend until plummeting from about 0.175 in 2012, then falls further to its lows of more than negative 0.2 in 2013 and 2014. A table beneath the graph shows that rolling returns for long bonds outperformed Libor over the last 20 years through June 2016: 73.9% for one-year returns, 88.3% for three-year,  and 99.6% for five-year. Asset class proxy indices are listed below the table.

In fact, with the equity overlay approach, our hypothetical investor could maintain her equity exposure at 60% while achieving a significantly higher expected return and lower incremental risk (Enhanced Scenario #1) when compared with the traditional re-risking approach. Alternatively, if she sought less return enhancement, she could match the return target of the traditional re-risking approach with 38% lower risk as in Enhanced Scenario #2. (See Figure 4.)

Figure 4 is a table that shows four different portfolio allocations, and the estimated return, volatility and estimated return per unit of risk (ratio). The four allocations include a 60/40 initial position, a traditional re-risking to 90/10, and two enhanced scenarios. Data and asset class proxy indices as of 30 June 2016 are detailed within.


Rising interest rates: While the long bond collateral could be negatively affected by rising rates in the short run, over the medium to long term long-duration bonds are likely to achieve a return consistent with their yield at the time of purchase (absent defaults) – and therefore may provide the expected return enhancement even in a rising-rate environment. In addition, rising interest rates are often accompanied by corporate spread tightening; this could potentially provide a partial offset to the impact of rising rates if a portion of the underlying long bond portfolio is invested in the corporate sector (see Figure 5).

Figure 5a and 5b feature two line graphs. Figure 5a shows hypothetical 1-year rolling return of the enhanced strategy (described below the charts) over the time period 2000 through mid-2016. Its peaks show 25% returns or greater at various periods, while its lows are just around negative 10%. The one-year rolling returns show wild fluctuations, from one year to the next. By contrast, Figure 5b graphs the 3-year and 5-year rolling returns over the same time period. Most of the time each is above zero, with the five-year rolling the least volatile over time. Asset class proxy indices are detailed below the charts.

The financing rate: The financing rate on the equity derivatives position will reduce the amount of return enhancement provided by the long bond portfolio. And as the yield curve flattens, return enhancement may be less significant.

However, we would suggest investors employing this strategy consider active management of the underlying long bond portfolio, as well as incorporating a certain amount of credit exposure to further enhance return potential and offset the possible impact of flatter yield curves. With long-dated corporate spreads (as measured by Barclays Capital Long Credit option-adjusted spread) currently yielding about 215 bps (compared with a historical average of about 150 bps) and the potential for alpha from active management, we believe return enhancement is possible even in a flatter yield curve environment. PIMCO CIO for Global Credit Mark Kiesel explores the potential of higher-quality credit in his latest Global Credit Perspectives.


In an era of lower expected returns, traditional approaches may fail to deliver the returns targeted or desired by pensions, other institutions and individuals in tax-deferred accounts (e.g., 401(k)s and IRAs). Investors could raise their expected return potential by increasing allocations to riskier asset classes, although doing so would come with higher volatility and risk.

In our view, a better and more efficient approach would be to replace current traditional physical equity exposure with synthetic equity exposure backed by long-duration bonds. This may enable investors to achieve an increased expected return over traditional equity exposure, with lower incremental volatility.

The Author

Mike Cudzil

Portfolio Manager

Rene Martel

Head of Retirement

Mohit Mittal

Portfolio Manager, Multi-Sector


PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe GmbH - Spain
Paseo de la Castellana, 43
28046 Madrid, Spain
Tel: +34 810 809 912

PIMCO Europe GmbH - France
50–52 Boulevard Haussmann,
75009 Paris

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. 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. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. 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.

Estimated returns for the indices contained herein are based on PIMCO capital market assumptions which are based on the product of risk factor exposures and projected risk factor premia which rely on historical data, valuation metrics and qualitative inputs from senior PIMCO investment professionals. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over a 10 year period. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. Return assumptions are subject to change without notice.

This material contains hypothetical examples for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays U.S. Long Credit Index is the credit component of the Barclays US Government/Credit Index, a widely recognized index that features a blend of US Treasury, government-sponsored (US Agency and supranational), and corporate securities limited to a maturity of more than ten years. Barclays Long Term Government/Credit Index is an unmanaged index of U.S. Government or Investment Grade Credit Securities having a maturity of 10 years or more. LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans. The MSCI All Country World Index is a free-float adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI All Country World Index consists of 46 country indexes comprising developed and emerging market indexes. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the manager 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.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the U.K. The Amsterdam and Italy branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie-Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-, Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (501 Orchard Road #09-03, Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein.| PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1o andar, Rio de Janeiro – RJ Brasil 22210-906. | No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2016, PIMCO.