PIMCO recently introduced the PIMCO Emerging Multi-Asset Strategy, a comprehensive emerging market (EM) portfolio solution for investors, providing dedicated exposure to key EM asset classes: equity, local sovereign debt, external sovereign debt, corporate debt and currencies. In an interview, portfolio managers who share responsibility for the strategy, Curtis Mewbourne, Maria (Masha) Gordon, Ramin Toloui and Michael Gomez, discuss the strategy’s investment process, the outlook for emerging markets and how this asset-allocation strategy integrates with PIMCO’s established investment framework.​

Q. What motivated the development of the PIMCO Emerging Multi-Asset Strategy?
Mewbourne: We believe that many emerging market countries are in the midst of a secular increase in global economic importance, and we expect them to grow at much faster rates than developed economies. While there are certainly risks in EM, including market volatility and currency risks, among others, we believe the potential benefits are enticing for investors and are motivating increased allocations to the space.

However, investors also realize that capturing these benefits is not as easy as making a simple buy-and-hold investment. First, the EM world is not homogeneous. There are some countries with strong fundamentals that are clearly ahead of the pack, while others still present considerable risks. The same is true on a corporate level. Also, there are different EM asset classes to consider beyond the broad equity allocations generally favored by investors. Each of these asset classes offers a different combination of risk and return potential. And of course there remains the higher volatility nature of the EM sector as a whole, as compared to most developed market investments, and particularly with respect to tail events, those outsized market shocks that have plagued the EM investor every handful of years.

So even though investors have turned to EM as a means to increase potential returns in their portfolios, they are simultaneously challenged to navigate fluid risks and exploit some significant opportunities along the way. Our view is that a passive approach to EM simply fails to address these realities. That’s the basis from which we believe PIMCO can help.

Q. What is the investment approach underpinning the PIMCO Emerging Multi-Asset Strategy?
Mewbourne: We’ve designed the PIMCO Emerging Multi-Asset Strategy to be a comprehensive EM solution for investors. Beyond just providing dedicated exposure to the key EM asset classes – equity, local sovereign debt, external sovereign debt, corporate debt and currencies – we also incorporate three distinguishing sources of active management.

First, we apply our “top-down” macroeconomic views to help manage the asset allocation across the EM asset classes. Second, we leverage our deep “bottom-up” EM expertise in each asset class to add excess return potential through relative value strategies and overall currency exposure management. Third, we incorporate “tail risk” hedging strategies as an additional way to add long-term return potential by seeking to limit losses during the periodic market crises that affect EM.

By combining these elements into a single portfolio, we’re able to offer investors a compelling comprehensive solution that combines the strategic exposure to EM that many investors desire with the robust risk management framework we feel they need. Bottom line: We think the approach of the Emerging Multi-Asset Strategy improves investors’ ability to maximize the return potential from their EM allocation, while better managing the risks inherent in this space.

Q. What are the roles of the four portfolio managers on the strategy?
Mewbourne: The strategy benefits by combining the deep EM experience of each portfolio manager with PIMCO’s asset allocation framework. Collectively we understand the EM universe, and each of us brings specialized knowledge of the specific asset classes. Masha Gordon leads our active EM equity business. She and her team of analysts bring a wealth of experience and insight to that asset class. Michael Gomez and Ramin Toloui co-lead our EM debt business. Michael manages our local EM debt and EM currency portfolios, and Ramin manages our external EM debt portfolios (EM bonds denominated in U.S. dollars). My job is to pull these components together in a manner that implements the three active management components of our multi-asset portfolios that I described earlier.

Q. How do you evaluate these asset classes and combine them into a single portfolio?
Mewbourne: Well, the nuts and bolts of the investment process begin with PIMCO’s three- to five-year secular outlook, which identifies key trends, risks and opportunities across the global economy. This is supplemented by our cyclical outlook, which specifies a near-term forecast for the level of economic growth and inflation in key regions. Next, PIMCO’s investment committee develops relative value views across key global risk factors.

Based on that framework, our four-person portfolio manager team works together to develop views on which specific EM regions, countries and industries will perform best. Similarly we develop views on interest rates, currencies and credit within the EM universe. The individual portfolio managers then make specific investments in their areas of expertise. These relative value decisions across and within the EM asset classes are important because there are different ways we can express a given view. For instance, sometimes a view on high growth in, say, Brazil may be best expressed through equities, while at other times the risk/reward may favor corporate bonds, or even short maturity Brazilian government bonds.

As a final step, we incorporate tail risk hedges, recognizing that risk in financial markets is not normally distributed. We want to limit losses associated with periodic market stress, which has unfortunately been a defining characteristic of EM investing in the past. Each of these three components – beta, alpha and tails – is designed to manage risk and deliver incremental returns over the traditional buy-and-hold approach.

Q. What are the key benefits of EM equities in the context of a diversified approach like the Emerging Multi-Asset Strategy?
Gordon: We believe emerging market equities are the most leveraged way to access the earnings growth and capital appreciation potential of companies based in nations that have increasingly become global centers of economic dynamism. Leading emerging nations have several factors favorable to long-term growth: less indebtedness, expanding middle classes, infrastructure investment and potential to drive domestic consumption. With these fundamental trends likely to continue, we believe that EM equity represents a compelling opportunity for investors.

Investor demand trends are supportive as well. EM equities have started to evolve from a satellite investment into more of a core allocation. Still, many investors remain under-invested in emerging markets, if we consider measures such as market cap weights of “all country” indexes or share of global GDP. Investors should also recognize that EM companies account for a substantial and increasing share of the global corporate profit pool.

Owing to these positive fundamental and demand trends, EM equities will be a key allocation within the Emerging Multi-Asset Strategy, roughly 50% of this portfolio as a long-term average.

Q. How do you manage your EM equity portion of the portfolio?
Gordon: We believe the key to success in emerging market equities lies in taking a holistic approach that combines a rigorous “bottom-up” driven stock selection process with a comprehensive “top-down” macroeconomic framework and sound risk mitigation techniques. My team selects from a very broad opportunity set of companies, emphasizing those that look cheap based on normalized earnings or intrinsic value. To assess this we use a proprietary valuation framework that incorporates many inputs, including a detailed analysis of company financials, discussions with company management, conversations with other industry participants and a full analysis of the capital structure.

A key differentiator to our EM equity process is the incorporation of PIMCO’s macro, sovereign and credit research views. These both inform our valuation framework and help us assess country and currency factors, which tend to have a pronounced impact on emerging market equity returns. In particular, expectations regarding growth and inflation over both cyclical and secular timeframes are key. We believe integrating these elements meaningfully enhances our ability to ultimately pick good companies in constructing our portfolio.

Q. Where does EM external debt fit into a strategy like Emerging Multi-Asset? And what are the risks of investing in U.S.-dollar denominated EM debt?
Toloui: Opportunities to generate return in emerging market external debt have expanded markedly in recent years, with the universe of issuers now encompassing much more than just sovereigns. As countries have increasingly turned to their domestic markets to finance government borrowing, EM corporate and quasi-sovereign issuers have come to represent the bulk of new external issuance.

While the case for EM sovereigns is fairly well understood, we believe the case for EM corporates is also compelling. From an investor’s perspective, these companies tend to have strong growth prospects and management teams, and often have better credit metrics – like lower leverage – than similarly rated developed market companies. In many cases, they are market leaders in their respective industries. And they tend to offer investors higher yields than their developed market peers. This reflects both an emerging market discount and the lack of dedicated investor sponsorship that U.S. and European investment grade and high yield credit enjoy.

The phrase “emerging markets” is a convenient term of reference, but there is important differentiation among various emerging market countries in terms of their levels of indebtedness, growth prospects and therefore ability to service debt. Given current investor enthusiasm for emerging markets as a group, there is a risk that pockets of overvaluation develop that are disproportionate to the ongoing risks. In this context, careful credit analysis and selectivity with respect to building a portfolio are critical.

In the context of the Emerging Multi-Asset Strategy, it’s also worth noting that emerging market debt may exhibit some defensive properties in times of market stress. This stems from two factors. First, as of February 2011 more than half of the JPMorgan Emerging Markets Bond Index (EMBI) Global is now investment grade rated and should benefit from the increase in U.S. Treasury prices during dislocations. Second, while we view EM currency exposure as a key long-term driver of returns in EM equity and local debt, the fact that external debt is denominated in U.S. dollars may help diversify the portfolio during periods of market turmoil when EM currency exposure from other parts of the Emerging Multi-Asset portfolio may weaken against the U.S. dollar and potentially other developed currencies.

Q. How are local EM bonds different from external EM debt?
Gomez: Local market instruments differ in a number of important ways. First, as their name suggests, these bonds are denominated in the currency of the issuer, for example: peso in Mexico, rupiah in Indonesia, rand in South Africa. Second, while they will naturally have exposure to the credit fundamentals of the issuing country, as with external debt, there are additional sources of both return and risk to consider when investing in local markets.

From a return perspective, local currency bonds tend to offer higher yields than hard currency-denominated bonds of similar maturity. Capital appreciation from yield compression will also be an important return driver, given the favorable secular fiscal and inflationary dynamics within many of these countries. Finally, returns will be impacted by movements in foreign exchange rates. We generally have a constructive view of EM currencies and expect they will appreciate over time, both to correct some of their longer-term undervaluation and as they benefit from the secular headwinds we see impacting major developed economy currencies.

Within a strategy like Emerging Multi-Asset, local market exposure may serve as both a return engine and in a defensive role. As mentioned above, local bonds have multiple compelling drivers of returns, which collectively give this portion of the EM opportunity set the potential for high long-term total returns, with a fraction of the volatility associated with EM equities. From a defensive perspective, local bonds tend to benefit structurally from on-going demand as a low risk asset for an ever-expanding base of local institutional investors and pension funds, which may provide some cushion during dislocations. We actually saw local debt yields fall rapidly following the stress of 2008, reflecting both the strong credit quality of many EM countries and the high demand for local EM investments even amid substantial developed economy stress.

Q. Even though the EM investment universe has a range of distinct asset classes, they all have exhibited a high correlation to EM equities. This is in contrast to the developed world, where stocks and bonds tend to diversify each other. What are the implications of this common EM risk factor to investors, and how do you manage this across the various EM assets?
Mewbourne: Excellent question. It is true that EM asset classes all share what we call EM equity risk, which essentially means they all tend to move with the EM equity market to varying degrees. In addition, many also share EM currency risk.

The first implication is the need to recognize that asset class diversification does not equate to risk diversification. That is why we use a risk-factor framework for guiding our allocation decisions, which is a distinguishing approach. The second implication is that there are varying combinations of assets that can be used to achieve similar risk factor targets. That reinforces our decision to have multiple PMs on the strategy, each able to contribute “bottom-up” relative value input to help identify the optimal mix of assets in achieving our risk-factor targets.

And the third implication is that a dedicated EM portfolio, though diversified, remains vulnerable to systemic shocks. That reinforces the need to have tail risk hedges. It also means that investors need to realize that they are taking strategic exposure to EM risk and must be prepared to ride the ups and downs of the investment accordingly. Our job is to make sure that ride is asymmetrical – potentially providing more upside participation and less downside participation.

Q. How should investors use the PIMCO Emerging Multi-Asset Strategy?
Mewbourne: We designed this to serve as a comprehensive EM solution, offering investors a comprehensive strategy to get dedicated EM exposure in a diversified, risk-aware fashion. We think the Emerging Multi-Asset Strategy is versatile in terms of how it can be used. Obviously, it can be a dedicated EM allocation and a consolidating strategy for investors who don’t want to make a piecemeal allocation to the various EM asset classes. It also can be viewed as a tactical asset allocation strategy, differentiated by its EM focus. Some may even choose to view it as an emerging market alternative strategy, given its tactical flexibility, embedded tail risk hedging and reduced volatility, as compared to a dedicated EM equity allocation.

Thank you.