Quantitative Research

October 2012

Analytics

Tactical Asset Allocation

With Macro Views:
From macro-forecasts to optimal portfolio construction

I. Introduction

PIMCO’s investment decisions are heavily influenced by our forecasts of the

likely path of the evolution of the global economy over the cyclical horizon and
the risks around our central scenarios. These evolving macroeconomic
forecasts (of growth rates of GDP, unemployment rates and other economic
indicators around the world) are anchored by discussions at our annual secular
forums, the quarterly cyclical forums and the Investment Committee (IC)
discussions following these forums. The gist of these deliberations can be
summarized in a set of probabilities for various economic outcomes defined
Ravi Mattu
Managing Director in terms of global growth and inflation over a cyclical horizon. For instance,
following the September 2012 cyclical forum, our outlook for real global GDP
growth over the next 12 months was in the range of 1.5% to 2% (below
Vasant Naik the current rate of 2.2%).1 At the same time there was recognition of risks
Executive Vice President around this base scenario. As our September 2012 Economic Outlook
mentions, “… while we do not expect recession across all developed countries
Mukundan Devarajan in 2013, we certainly would caution that the probability of a widespread
Senior Vice President recession has increased, given the coordinated slowdown in global aggregate
demand we are witnessing across the world.”2 It was noted, however, that the
decision of the European Central Bank to commit its balance sheet to
Masoud Sharif unlimited but conditional purchases of short-term eurozone government
Vice President
bonds “… substantially reduced the probability of depression like left-tail risk
over our cyclical horizon.” Such a layered and nuanced assessment of the
balance of probabilities of different macro-economic scenarios is a regular
and crucial part of the PIMCO investment process.

Another important input into our investment process is the forecast of returns
on the major investment choices we have under specific economic scenarios.
In our investment process, the sector-wise forecasts of asset returns conditional
on different macro scenarios emanate from teams that specialize in particular
market segments, while the IC defines the relevant macro-economic scenarios,
evaluates the balance of macro-economic risks and vets the scenario return
forecasts. In this way, the investment guidelines for our portfolio managers

Originally published by Ravi Mattu, Vasant Naik, Peter Matheos, Mukundan Devarajan and Masoud Sharif.
 worldwide are the outcome of a process that takes its inputs We estimate within-scenario risk from historical data while
from both a top-down and a bottom-up view of the macro- the uncertainty caused by scenario shifts is derived from
economic and market environment. variation in return forecasts across scenarios. In this way,
our methodology combines rich historical data on return
We can also utilize a framework for tactical asset allocation
volatilities and correlations with the forward-looking views
that integrates the parameters codifying PIMCO’s cyclical
emanating from our deliberations.
macro-economic outlook in a quantitative methodology for
optimal portfolio construction. We have applied elements Finally, we use a mean-variance analysis to combine the
of this framework to advise our IC and individual portfolio above-mentioned inputs and arrive at potentially optimal
managers in their portfolio construction process. Our process overlays. In our optimization, we typically constrain the solution
begins by specifying the probabilities of broad macro-economic to remain within reasonable bounds as well as to ensure that
scenarios and then combines them with the estimates of the procedure does not attempt to leverage small differences
returns in different scenarios and the historical volatilities and in returns by taking large long-short positions in highly
correlation among asset returns in an effort to create correlated assets. Liquidity-based constraints that require that
optimal portfolios. the solution move only gradually from existing positions that
are considered illiquid are also applied.
Our central premise is that the return forecasts for various
markets in different scenarios are best understood as II. Return Estimation
conditional averages of returns (i.e., averages conditional on
How do we estimate returns on various assets that are the first
particular scenarios) rather than the only possible values of
key input for the optimal overlay analysis? Let us look at a
returns in those scenarios. This is because a given scenario
hypothetical example. PIMCO has characterized the secular
represents a range of possible but related outcomes, and while
outlook for the global economy as being in a “New Normal”
real growth and inflation shocks may be the most important
era of sub-trend growth with a non-negligible probability of
drivers of returns, other asset-specific factors ranging from
left-tail events. Consistent with this characterization and in
housing finance related policy variables in agency mortgages to
the context of our discussion at the September 2012 Cyclical
geopolitical supply shocks in oil markets help determine market
Forum, three scenarios can be considered probable over the
outcomes. Scenario probabilities together with the forecasts
cyclical horizon, which we take to be one year:
of returns in various scenarios then allow us to compute the
estimated returns on various assets over the cyclical horizon. 1. Base: slow but continuing global growth and
To estimate risk we recognize that there are two sources of moderate inflation
uncertainty: the uncertainty about which scenario will be
2. Pessimistic: outright recession
realized and the uncertainty around conditional means of
(without a financial, banking or sovereign crisis)
returns within each scenario. In the context of the discussions
at the September 2012 Forum, there are two sources of risk 3. Tail: deep recession accompanied by a
to the base case forecast of a deceleration in global economic financial/sovereign crisis
activity. The first and obvious risk is the possibility of markedly
The first ingredient of the computation of estimated returns
less robust growth than expected (i.e., that a more pessimistic
is a set of scenario forecasts of returns on various asset
scenario than the base case or that even a tail scenario occurs).
classes. See Figure 1a.
The second set of risks comes from the fact that the projection
of asset returns in a given scenario does not cover the full Scenario forecasts of returns on various assets should reflect
range of probable outcomes even within that scenario. Our the macro behavior of these returns as well as valuation
risk estimates account for both of the above sources of risk. considerations. Our example captures the property that

2 OCTOBER 2012 | QUANTITATIVE RESEARCH

relatively riskless assets rally in the pessimistic and tail scenarios horizon. There is a substantial probability that either the
while the risky assets outperform in the base case. Valuation pessimistic or the tail scenario will occur. As we show later,
considerations also play an important role in these forecasts. optimal portfolio overlays will reflect this view. If these
In the example below, it is assumed, for instance, that German probability assessments change and the relatively benign
government bonds have a much more pronounced downside base case becomes more likely, the optimal overlays would
in the base case than do U.S. Treasuries. This incorporates the change too.
view that the ongoing sovereign crisis in the eurozone may
Given a set of scenario probabilities, it is straightforward to
have led to an unusually large compression in German
compute return estimates for various asset classes. The
government bond yields. This might normalize abruptly if there
(unconditional) estimated returns are simply the probability-
were a definite move toward a meaningful resolution of the
weighted averages of scenario forecasts (Figure 1b).
European situation (an outcome more likely to be associated
with the base scenario than with the pessimistic or tail III. Forecasting Volatilities
scenarios). In addition, our example assumes that risky assets
Our key observation is that estimates of asset return volatility
(corporate bonds and equities in particular) are already pricing
must account for the volatility of returns within each scenario
in a substantial level of optimism, hence the upside in these
as well as the volatility across scenarios, which is due to the
assets in the base case is limited while the loss potential,
uncertainty about which scenario will be realized. That is,
especially in the tail scenario, is large.
Var (asset returns) = E (Scenario variance) + Var (Scenario
The next ingredient that we need to compute estimated forecast) where Var (-) denotes Variances and E (-) denotes
returns is an assessment of the probabilities of the above expected values.
scenarios. We take these to be 0.55 (base scenario), 0.40
We estimate the volatility of each asset under the base-case
(pessimistic scenario) and 0.05 (tail scenario), in line with the
(55% probability) and the pessimistic/tail scenarios (45%
IC’s assessment of probabilities following the September 2012
probability) from historical data. We use the 10-year period
Cyclical Forum discussions. These probabilities imply a
ending in June 2008 as a proxy for the base scenario and the
cautious assessment of the global economy over the cyclical
four-year period from July 2008 to September 2012 as a proxy

FIGURE 1A: CONDITIONAL ESTIMATED EXCESS RETURNS FOR KEY ASSETS (% P.A., AS OF 28 SEPTEMBER 2012)
(Estimated excess returns for government bonds, currencies, equities and oil are over short-term interest rates while those for credit and mortgage-backed
securities are over duration-matched Treasuries)

Base Pessimistic Tail

US Treasury 5-10y -2.9 3.4 6.3
DE Government 5-10y -10.2 4.0 8.8
US MBS 0.4 -0.1 -1.2
US Corp Financials 4.2 -7.4 -17.5
US Corp Non Financials 5.5 -0.8 -10.8
EUR (v. USD) 2.4 -12.5 -31.6
AUD (v. USD) 7.2 -7.9 -21.0
BRL (v. USD) 18.1 0.7 -11.7
US Equities 2.0 -19.9 -34.4
EM Equities 7.2 -13.6 -36.2
Oil 7.0 -23.0 -44.4
Source: PIMCO
Hypothetical example for illustrative purposes only.

QUANTITATIVE RESEARCH | OCTOBER 2012 3

for the pessimistic/tail scenarios. The estimation of volatilities base, pessimistic or tail scenario will be realized). Figure 2
conditional on different economic regimes is justified by the illustrates this two-step estimation of volatility transparently.
observation that both volatility and risky asset correlations are The final volatility estimates are shown in column 5.
elevated in stressed environments. Accordingly, our estimate of
the volatility of S&P 500 returns is 13.8% in the base scenario Comparing our estimate of the total volatility of each asset
versus 18.0% for the stressed scenarios. The impact of higher class (column 5) with the estimates in column 4 (the volatility
equity volatility on diversified portfolios is magnified by an implied from the return forecasts in the three possible
increase in the correlation of these returns with the returns of scenarios) shows the stark differences that appear in the
other risky assets in stressed periods. The correlation of S&P relatively more risky asset classes. For instance, the volatility of
500 returns with the excess returns (over duration-matched scenario forecasts for oil is only 16.7% per year. This contrasts
Treasuries) of U.S. investment grade non-financials is estimated with a historical volatility of over 30% in the previous 14 years
at 0.53 for the base case and 0.65 for the stressed cases. The (columns 1 and 2). Our estimate for future volatility is 35.2%
increase in correlation during stress is even more pronounced per year. Similarly, the volatility of the EUR/USD currency pair
for oil, whose estimated correlation jumps from 0 to 0.7. increases from 9.4% to 14.4%. By adjusting these volatilities
higher we lower our confidence in tilting the portfolio toward
We add to this scenario-specific volatility the volatility being short oil or short the euro. Above Figure 2 are detailed
generated by the possibility of scenario switches (i.e., the descriptions of our computations.
volatility caused by not knowing in advance whether the

FIGURE 1B: ESTIMATED RETURNS FOR KEY ASSETS (% P.A., AS OF 28 SEPTEMBER 2012)
(Estimated excess returns for government bonds, currencies, equities and oil are over short-term interest rates while those for credit and mortgage-backed
securities are over duration-matched Treasuries)

Base Pessimistic Tail

Probability 55% 40% 5% Estimated excess returns
US Treasury 5-10y -2.9 3.4 6.3 0.1
DE Government 5-10y -10.2 4.0 8.8 -3.6
US MBS 0.4 -0.1 -1.2 0.1
US Corp Financials 4.2 -7.4 -17.5 -1.5
US Corp Non Financials 5.5 -0.8 -10.8 2.2
EUR (v. USD) 2.4 -12.5 -31.6 -5.3
AUD (v. USD) 7.2 -7.9 -21.0 -0.3
BRL (v. USD) 18.1 0.7 -11.7 9.7
US Equities 2.0 -19.9 -34.4 -8.6
EM Equities 7.2 -13.6 -36.2 -3.3
Oil 7.0 -23.0 -44.4 -7.6
Source: PIMCO
Hypothetical example for illustrative purposes only.

4 OCTOBER 2012 | QUANTITATIVE RESEARCH

Column 1: We estimate volatility under the base scenario from European sovereign debt crisis and is a reasonable proxy for
the historical volatility of excess returns over the 10-year period such scenarios. As before, we clip the top and bottom 5% of
ending in June 2008. We recognize that it is simplistic to the distribution. Given that the tail scenario is a low probability
describe a decade that included periods of optimism about extreme outcome, we do not attempt to estimate volatilities
productivity growth as well as the bursting of both the tech separately in this scenario. Instead we use a composite
and real estate bubbles as constituting a single regime. There pessimistic/tail scenario.
were periods in the decade where market sentiment turned
Column 3: Average conditional volatility is computed from
from exuberance to caution (reflecting the possibility of regime
the weighted average of scenario variances given in columns
switches). Therefore, to make the volatilities more consistent
1 and 2 where the weights are set equal to the probabilities
with the base scenario, we remove the effect of extreme
assigned to these scenarios.
observations by clipping the distribution of returns in the
bottom and top 5%. (That is, for each series individually the Column 4: The additional volatility due to the possibility of
returns in the bottom 5% are set to the 5th percentile return regime switches is estimated from the variance of scenario-
while those in the top 5% of the distribution are capped at the specific return forecasts. When the forecasts differ a lot across
95th percentile.) scenarios and it is highly uncertain which scenario will
Column 2: The four-year period from July 2008 to September materialize, this component will contribute more to the overall
2012 is used as a proxy for pessimistic/tail scenarios. This volatility of returns. Box A presents an example that clarifies
period includes both the financial crisis of late 2008 and the the value of including forward-looking views in our estimates
of volatility.

FIGURE 2: VOLATILITY ESTIMATES FOR EXCESS RETURNS OF SELECT ASSET CLASSES (%, ANNUALIZED, AS OF 28 SEPTEMBER 2012)

1 Base Scenario 2 Pessimistic/Tail 3 Average Conditional 4 Volatility of

Volatility Scenario Volatility Volatility Scenario Forecasts 5 Total volatility
(3) = 0.55*(1) + 0.45*(2)
2 2 2
(5)2 = (3)2 + (4)2
US Treasury 5-10y 1.6 3.3 2.6 3.3 4.2
DE Govt 5-10y 1.2 2.8 2.1 7.4 7.7
US MBS 0.6 1.0 0.8 0.4 0.9
US Corp Financials 2.9 4.5 3.7 6.7 7.6
US Corp Non Financials 2.8 4.5 3.7 4.2 5.6
EUR (v. USD) 8.4 13.4 11.0 9.4 14.4
AUD (v. USD) 9.9 17.1 13.6 8.7 16.1
BRL (v. USD) 12.9 15.4 14.1 9.7 17.1
US Equities 13.8 18.0 15.8 12.1 19.9
EM Equities 17.1 16.6 16.9 12.5 21.0
Oil 30.8 31.1 30.9 16.7 35.2

Source: PIMCO, Barclays, Bloomberg

Hypothetical example for illustrative purposes only.
See appendix for asset proxy information.

QUANTITATIVE RESEARCH | OCTOBER 2012 5

Column 5: Finally, we estimate total volatility from the regularities in the behavior of rates and spreads. In particular,
weighted scenario-specific volatility (“expectation of our estimates account for the observation that the volatilities of
conditional variance,” column 3) and the volatility across changes in interest rates and credit spreads tend to depend on
scenarios (“variance of the conditional means,” column 4). their levels. Hence, our method models the dynamics of yields
and spread as a lognormal rather than a normal process, so
Empirical Regularities Reflected in Historical Estimates that changes in yields and spreads are proportional to the
It bears mentioning that the historical estimation that we current level of these variables. Thus the 1.6% return volatility
use for scenario-specific volatilities accounts for the empirical of U.S. five- to 10-year government bonds in the base

Box A: The Value of Combining Historical Experience With Forward-Looking Views: The Case of European
Sovereign Spreads

As the discussion in Section II makes clear, our estimates of risk parameters combine historical data with the volatility
generated in scenario forecasts. Since scenario probabilities and the forecasts themselves are forward-looking, our
framework incorporates a combination of historical experience and forward-looking assessments.

The value of such a combination can be easily seen in the case of European sovereign spreads (although peripheral
European government bonds are not included in the example presented in this article). Figure 3 below shows the time
series of the spread of generic 10-year Italian bonds over German bunds. The spread level and its volatility have increased
considerably in the last two years. However, even with this heightened spread uncertainty, the history does not include any
observation that would come close to what is being contemplated in the tail scenario in our example. This scenario includes
the possibility of a full-blown sovereign crisis in which case spreads and volatility could reach unprecedented levels. Our
estimates of total volatility take into account a forward-looking assessment of spread levels in this scenario and the volatility
introduced by this forecast. Thus, our framework uses a more realistic estimate of the risk of these assets than the case
where we rely on historical data alone.

FIGURE 3: SPREADS OF ITALY GOVERNMENT BONDS OVER GERMANY GOVERNMENT BONDS

(2006-2012, AS OF 28 SEPTEMBER 2012)

600
n IT - DE 10y spread 2010 average
500 2011 average 2012 average

400
BPS

300

200

100

0
Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
‘06 ‘06 ‘07 ‘07 ‘08 ‘08 ‘09 ‘09 ‘10 ‘10 ‘11 ‘11 ‘12 ‘12
Source: Bloomberg

6 OCTOBER 2012 | QUANTITATIVE RESEARCH

scenario would be approximately equivalent to a 3.2% return estimates as our method does. The methodology used in
volatility if initial yields were twice the current levels. estimating volatilities in Section III can be extended to
estimating correlations. As before, we measure correlations for
IV. Forecasting Correlations
the base scenario using the clipped historical distribution of the
Portfolio optimization also requires a view on return 10-year period prior to June 2008 (Figure 4a) and those for
correlations. If the scenario forecasts of returns were thought the composite pessimistic/tail scenario using the more recent
of as the only possible outcomes of returns in the given four-year period (Figure 4b). The fact that correlations tend
scenarios, the correlations that would result among various to increase in stressed environments comes through in these
assets would be extreme. When return forecasts are subjected estimates. It can be seen, for example, that over the 10-year
to the discipline of having to be created for economic scenarios period ending in June 2008 U.S. equity (S&P 500) returns had a
defined in terms of growth and inflation surprises, these zero correlation with oil. Over the subsequent four years this
forecasts will appear to have been generated by a one-factor return correlation was 0.7. Clearly, the decade prior to 2008
model (“risk on/risk off”) even if different groups create them. reflects a period where energy markets were driven by both
However, as a principal component analysis of returns on supply and demand fundamentals, while recent history has
macro-assets shows, the first principal component (which can been dominated by macro shocks that have affected global
be identified as the risk on/off factor) explains less than 60% demand. A similar story can be told about other asset pairs.
of the return variation across broad asset classes, even in recent
As before, we blend history with forward-looking correlations
episodes of financial stress. This bolsters the case for allowing
embedded in the forecasts of returns in various scenarios.
scenario-specific uncertainty in returns to be applied to risk
We put a 55% weight on the normal-period covariance

FIGURE 4: CORRELATION MATRIX OF EXCESS RETURNS ON SELECTED ASSET CLASSES AS OF 28 SEPTEMBER 2012
a. Normal period: Jul 1998 – Jun 2008

US Treasury US Corp US Corp Non

5-10y Financials Financials EUR (v. USD) US Equities Oil
US Treasury 5-10y 1 -0.35 -0.43 0.30 -0.39 0.05
US Corp Financials 1 0.85 -0.02 0.42 -0.01
US Corp Non Financials 1 -0.01 0.53 0.08
EUR (v. USD) 1 -0.07 0.09
US Equities 1 -0.02
Oil 1

b. Stressed period: Jul 2008 – Sep 2012

US Treasury US Corp US Corp Non
5-10y Financials Financials EUR (v. USD) US Equities Oil
US Treasury 5-10y 1 -0.45 -0.48 -0.02 -0.29 -0.30
US Corp Financials 1 0.91 0.49 0.68 0.46
US Corp Non Financials 1 0.46 0.65 0.49
EUR (v. USD) 1 0.68 0.52
US Equities 1 0.70
Oil 1
Source PIMCO, Barclays, Bloomberg

QUANTITATIVE RESEARCH | OCTOBER 2012 7

matrix (that uses the values in Figure 4a) and a 45% weight The correlation matrix that results from the shrinkage exercise
on the stressed-period covariance matrix (using the values is the one we use for the optimization exercise. As can be seen
in Figure 4b) to obtain the covariance analog of column 3 from the extract shown in Figure 5b, the correlation estimates
of Figure 2. We then add the covariance matrix of scenario are intuitive but they should be treated as a starting point in
forecasts to this weighted historical covariance matrix. the optimization process. For instance, one may view the
return correlation of 0.74 between the excess returns of
Applying a Shrinkage Procedure to Impart Robustness financial and non-financial corporate bonds as too low over
in Correlation Estimates the cyclical horizon. Such views could be incorporated into the
The resulting variance-covariance matrix may still imply correlation matrix (with minimal adjustments to ensure internal
spuriously high correlations between some assets, potentially consistency or “positive-definiteness” of the resulting
giving rise to instabilities in an optimization exercise. Hence, covariance matrix) to better reflect these views.
as a final step we tilt the estimated correlation matrix toward
a matrix that assumes that all assets are uncorrelated. While V. Optimal Overlays
the assumption of uncorrelated assets is clearly counter-factual,
The prospective estimated returns on various assets and the
there is substantial evidence in financial and statistical studies
variance-covariance matrix of their returns represent the most
that a tilt of estimated correlations toward zero generates
important inputs needed to analyze the optimal risk/reward
valuable stability in portfolio analyses. Figures 5a and 5b
trade-off. To illustrate the interplay between risk and reward in
clearly show the moderating effect of applying this shrinkage
the determination of optimal overlays, we first take the case
to our correlation matrix.

FIGURE 5: COMBINED HISTORICAL AND FORWARD-LOOKING CORRELATION MATRIX AS OF 28 SEPTEMBER 2012

a. Before shrinkage
US Treasury US Corp US Corp Non
5-10y Financials Financials EUR (v. USD) US Equities Oil
US Treasury 5-10y 1 -0.81 -0.75 -0.47 -0.63 -0.46
US Corp Financials 1 0.93 0.68 0.76 0.52
US Corp Non Financials 1 0.64 0.76 0.52
EUR (v. USD) 1 0.63 0.52
US Equities 1 0.53
Oil 1

b. After shrinkage
US Treasury US Corp US Corp Non
5-10y Financials Financials EUR (v. USD) US Equities Oil
US Treasury 5-10y 1 -0.65 -0.60 -0.38 -0.51 -0.37
US Corp Financials 1 0.74 0.55 0.60 0.42
US Corp Non Financials 1 0.51 0.61 0.42
EUR (v. USD) 1 0.50 0.42
US Equities 1 0.43
Oil 1
Source: PIMCO, Barclays, Bloomberg
Hypothetical example for illustrative purposes only.

8 OCTOBER 2012 | QUANTITATIVE RESEARCH

when there are no constraints on the overlays to be Imposing Constraints
considered. Figure 6 presents this unconstrained optimal
While this simple exercise reveals interesting trade-offs
overlay using the estimated returns of Figure 1b (column 4)
between competing trades in a convenient fashion, an
and the variance-covariance matrix estimated using the
unconstrained optimization exercise is not a realistic one. In
method described in the previous sections. This portfolio
practical situations, we must take into account the liquidity
overlay maximizes the estimated mean alpha for a target
of various markets, strategic positions in portfolios, as well as
volatility of 200 bps per year.
mandate restrictions. The mean-variance optimization analysis
The above results reveal a number of interesting insights. used above can be modified easily to take account of such
1. The unconstrained optimum seeks to be overweight U.S. constraints. The overlay is constrained in terms of the
duration where the estimated returns are positive. This maximum and minimum exposures we can take in certain
position is accentuated by the fact that there is an asset classes. Equally importantly, we impose constraints that
offsetting underweight position in German duration. This limit the extent to which the optimizer can pick offsetting
is driven by the negative estimated returns for German overweight and underweight positions in highly correlated
government bonds as well as the high correlation between assets. Again, the objective of the optimization exercise is
U.S. and core-Euro rates. to select an overlay portfolio to maximize estimated returns
subject to a volatility of 200 bps per year. See Figure 7 for the
2. There is a significant overweight in U.S. non-financial
optimization constraints and the optimal overlay.
credit (supplemented by an underweight in U.S. financial
credits). This combination is an attempt to take advantage
FIGURE 6: UNCONSTRAINED OPTIMAL OVERLAY AS OF 28 SEPTEMBER
of the negative estimated returns of financials and the 2012: TARGET VOLATILITY 200BP
significant correlation between financials and non- (See note for units)
financial credits. Unconstrained optimal overlay
US Treasury 5-10y 1.2
3. U.S. MBS are attractive. This results from the positive
DE Govt 5-10y -1.7
estimated returns and also from the fact that the returns
Credit US Financials -1.7
of this asset class have only moderate correlations with
Credit US Non Financials 2.6
other assets.
US MBS 0.5
4. An underweight position in equities is not surprising given EUR (v. USD) -7.6%
their negative estimated returns. Moreover, the model seeks AUD (v. USD) 2.6%
to overweight the Brazilian real (BRL) and Australian dollar BRL (v. USD) 8.0%
(AUD). Despite a higher estimated return, the underweight US Equities -2.1%
in EM equities is larger than in U.S. equities. This is because EM Equities -6.1%
the BRL position is markedly positively correlated with EM
Oil -1.0%
equity positions and a better risk-reward tradeoff is reached
Estimated mean alpha (bp, p.a.) 361
by underweighting EM equities and being overweight
Target volatility (bp, p.a.) 200
BRL (and AUD).
Note: Risk exposures to all assets other than Currencies, Equities and Oil are in years of
duration overweight (+) or underweight (-). Those of Currencies, Equities and Oil are in
percentage market value.
Source: PIMCO
Hypothetical example for illustrative purposes only.

QUANTITATIVE RESEARCH | OCTOBER 2012 9

With constraints, the framework suggests a smaller overweight VI. Conclusion
position in U.S. duration and a correspondingly smaller PIMCO’s framework synthesizes the forward-looking views
underweight in German duration as there are restrictions about asset returns in macro-scenarios considered likely at the
imposed on large opposite trades in correlated assets. The cyclical horizon into a set of optimal overlay positions, while
overweight in MBS duration is maximal given the attractiveness explicitly accounting for return volatilities and correlations
of its estimated returns and correlation properties. Moreover, observed in historical data. Undoubtedly, such a framework is a
again because offsetting opposite positions are restricted, starting point to determining an optimal set of overlay trades.
both credit positions are overweights. However, there is a
bigger underweight in equities that acts as a partial hedge It allows for views to be taken on its various inputs, which can
to these credit positions. Also, the aggregate upper bound make its proposals richer and more representative of strategic
in currencies is binding. That is, the model would want to and macro considerations. In future extensions of our work,
overweight BRL and AUD more (and underweight EUR more) we will include measures of risk other than variances (such as
against USD if it could. A net short in these currencies is not conditional VaR) in the optimization procedure for cases where
chosen to hedge the credit overweights. they might be more appropriate.

FIGURE 7: OPTIMAL OVERLAY WITH CONSTRAINTS AS OF SEPTEMBER 2012: TARGET VOLATILITY 200BP
(See notes for units)
Constrained optimal overlay Constraints imposed
US Treasury 5-10y 0.3
DE Govt 5-10y -0.3
Credit US Financials 0.7
Credit US Non Financials 1.6
US MBS 1.0 -1 – 1 year
EUR (v. USD) -1.1%
AUD (v. USD) 1.2% -5% – 5%
BRL (v. USD) 4.9%
US Equities -2.9%
-10% – 10%
EM Equities -7.1%
Oil -4.4%
Estimated mean alpha (bp, p.a.) 196
Target volatility (bp, p.a.) 200
Notes: 1. Risk exposures to all assets other than Currencies, Equities and Oil are in years of duration overweight (+) or underweight (-). Those of Currencies,
Equities and Oil are in percentage notional. 2. We impose constraints on matching over/underweight positions across buckets within Rates, Credit,
Currencies and Equities.
Source: PIMCO
Hypothetical example for illustrative purposes only.

10 OCTOBER 2012 | QUANTITATIVE RESEARCH

Appendix
Indexes used to compute historical volatilities and correlations (reported in Figures 2, 4
and 5)
n U.S. Treasury 5-10y: Barclays US Treasury 5-10 year index monthly total returns, less
USD 1M funding (Source: Barclays Capital)
n DE Government 5-10y: Bloomberg EFFA Germany 5-10 year index monthly total

returns, less EUR 1M funding (Source: Bloomberg)

n US MBS: Barclays US Aggregate MBS Index monthly excess returns over duration-

matched Treasuries (Source: Barclays Capital)

n US Corp Financials: Barclays US Credit Financials Index monthly excess returns over

duration-matched Treasuries (Source: Barclays Capital)

n US Corp Non Financials: Merrill Lynch US Corporate Non-Financial Index monthly

excess returns over duration-matched Treasuries (Source: Merrill Lynch Indices)

n EUR: Monthly returns of a 1M forward contract on EUR/$, held to expiry (Source:

Bloomberg)
n AUD: Monthly returns of a 1M forward contract on AUD/$, held to expiry (Source:

Bloomberg)
n BRL: Monthly returns of a 1M forward contract on BRL/$, held to expiry (Source:

Bloomberg)
n US Equities: MSCI US Equity Index monthly total returns, less USD 1M funding

(Source: Bloomberg)
n EM Equities: MSCI EM Total Return Index monthly returns less monthly returns of

MSCI FX hedge index (Source: Bloomberg)

n Oil: S&P GSCI Crude Index monthly returns (Source: Bloomberg)

1
Parikh, S., “PIMCO Cyclical Outlook: Building Rickety Bridges to Uncertain Outcomes,”
p. 4 (Table 1), PIMCO Economic Outlook, September 2012.
2
Ibid, p. 3

QUANTITATIVE RESEARCH | OCTOBER 2012 11

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