London (HedgeNordic) – PIMCO’s commitment to quantitative strategies, and its distinctive environment for quant research, were first developed in 2003, the year its quant platform was founded. But the area received a boost when CEO Emmanuel Roman joined PIMCO in 2016 and made quant a strategic priority, and was further strengthened when Managing Director and Portfolio Manager Nick Granger (pictured) joined in 2020.
“Moving to an organization with institutional support for quant from the top level in terms of resourcing, technology, and data, was very important”, says Granger, who also finds the West Coast US California lifestyle a refreshing change from London. “It is a very collaborative firm where quant is not siloed but is mixed into the rest of the investment management effort. This widens our opportunity set into areas such as one of the world’s leading mortgage trading desks,” points out Granger. The broader quant platform at PIMCO has grown to over 150 people.
PIMCO has built out a variety of quant strategies to take advantage of opportunities, in areas such as emerging markets (EM) fixed income, volatility instruments and credit. For instance, the firm’s distinctive alternative risk premia (ARP) strategy has gone beyond classic carry, momentum and value factors. It exploits risk premia in mortgages, volatility and credit markets, as well as seasonality premia in commodities, leveraging specialist expertise. The multi-strategy hedge fund has been successful at systematically trading credit. PIMCO’s ’trendfollowing commodities trading advisor (CTA) strategy has become the largest US mutual fund in this space and the strategy can also be accessed in UCITS format.
Defined Use of Discretion
The integration of discretionary and systematic analysts and portfolio managers raises questions about division between the styles, and the firm carefully defines where discretion can and cannot enter the process. “We will not try to second guess quant models,” explains Granger. “We need to be very careful and humble about what we know and what we do not know. We run a model and intervening in models with any regularity tends to detract value. We build robust models to take advantage of inefficiencies, rather than trying to time markets.”
“We need to be very careful and humble about what we know and what we do not know.”
Yet geopolitics is one area that can trigger discretionary intervention. “Our EM specialists are monitoring emerging markets in real time and can alert us to worrying events at an early stage. Our advisory board includes Ben Bernanke and former UK prime minister Gordon Brown. Where experts have a very strong view we may exit a position, but we would not reverse it to the opposite direction”.
Trade execution is another area where humans cannot be replaced by machines in all areas. Quant strategies that trade only the most liquid markets may fully automate everything including execution, but PIMCO does not trade all markets through electronic algorithms. “In less liquid markets and those with sporadic liquidity, quant models assuming full liquidity do not work. We make use of counterparty relationships and discretionary execution using human traders to source over-the-counter (OTC) markets,” says Granger.
AI and Machine Learning
As with discretion, Granger is very selective about appropriate uses of artificial intelligence and machine learning techniques. He argues: “Machine learning works well with millions of data points, shorter or high-frequency holding periods, and very broad investment universes such as equities. But in financial markets with a low signal-to-noise ratio, there is a danger of data mining and over-fitting. Whereas we seek parameter robustness. We prefer ideas to be underpinned by fundamental insights and observations. We generate hypotheses and use data to verify or disprove them. The majority of our work is fundamental. Therefore, we might use machine learning techniques to transform sentiment data, images or audio data, into a numerical value, rather than using it directly.”
“We have a strong belief that trend is a unique style. Very few things have similar longterm positive alpha and diversifying characteristics.”
Pure Play Trend (with Some Filters)
PIMCO’s trend-following program is a pure play: “We have a strong belief that trend is a unique style. Very few things have similar long-term positive alpha and diversifying characteristics. We do not want to fit-in overly clever stuff or switch to mean reversion when trend stops working.” Yet Granger believes that trend can be enhanced with some fundamental insights, such as seasonality, storage costs, and forward curve modelling for commodities. These can be used to filter or temper trend signals – but will never lead to an anti-trend position.
For instance, the inverse correlation between trend and carry strategy performance is well documented and is heeded at PIMCO. “At the individual market level, negative carry – such as crude oil in steep contango – would eat into expected returns from a long position and could lead to zero position, but would not lead to a counter-trend position. Conversely, positive carry could be enough to counterbalance a short trend signal and result in no position”. In addition, PIMCO can sometimes invest beyond the front month future or contract, to optimize carry dynamics.
Designed to be Defensive
Granger argues that the PIMCO trend strategy aims to be relatively defensive for three reasons: style purity, trading speed and overrides on equity exposure. “Pure trend signals are not modified with other signals designed to smooth out performance when trend following is harder. Faster trend signals tend to be more defensive and improve positive skewness. They turn around and respond more quickly, especially when there is a new emerging theme such as COVID-19 in late February 2020”. There is also an explicit cap of 0.5 on equity upside beta, with somewhat more latitude on the downside.
When markets see a bolt-out-of-the-blue drawdown, such as in February 2018, a long equities position can exacerbate drawdowns. “We therefore manage long exposure to ensure that we are not caught the wrong way”. The equity beta cap is calculated using both direct equity exposures and equity beta from other asset classes, where credit and emerging markets have the most notable equity market correlations. Some ARP versions of the strategy have also been calibrated with lower equity beta caps.
Defining “Traditional” and “Alternative” Markets
PIMCO has various versions of trend following. The trend sleeve within Alternative Risk Premia ARP programmes usually matches the flagship trend strategy (except for the versions with lower equity beta). The multi-strategy hedge fund exclusively focuses on relatively unique alternative and exotic markets and the pure trend-following strategies also have a significant weighting in these “alternative markets”, even if they are not purely comprised of them in the way that some dedicated alternative markets CTAs are.
However, Granger argues that the split between “traditional” and “alternative” markets is to some extent a false dichotomy, partly due to PIMCO’s existing market relationships. “Whereas most CTAs started trading futures and viewed a move into swaps as alternative, PIMCO sometimes finds it easier to trade swaps than futures”. Key “alternative” markets traded by PIMCO include emerging market rate swaps and currency forwards, mortgages, electricity, and emissions. These markets can be harder to access but PIMCO has extensive OTC counterparty relationships, and manages counterparty risk carefully.
Any perception that alternative markets are less liquid is not a useful generalization, according to Granger: “The traditional futures universe contains markets such as cotton, cocoa and orange juice, which can have very limited liquidity. Meanwhile, US mortgages, credit indices and swaps boast better liquidity than most futures markets”. Therefore, Granger sees plenty of scalability, though PIMCO’s large asset base reduces any incentive to grow the strategy beyond optimal capacity, or indeed deviate from its stated style. “Even as the quant business grows, it will always be a relatively small part of the overall PIMCO business, so there is no pressure to grow assets by increasing weights in more liquid markets, or dilute the long-term diversification objectives of the strategy for the sake of short-term fee income,” argues Granger.
Collateral Management and Credit Risk Premia
Most CTAs are sitting on substantial amounts of cash and benefitting from higher risk-free interest rates in 2022 and 2023. PIMCO’s active collateral management aims to add a meaningful return on top of risk-free rates, through techniques such as repos, margin optimization and netting, and highly diversified exposure to highly rated short-term commercial paper issued by corporates. This does entail some degree of corporate credit risk premia, though Granger stresses that it is highly diversified. Clients with separately managed accounts could, of course, opt to keep cash in Treasuries or even consider other liquid fixed income strategies.