An Upgrade for This Quirky Large-Blend Fund

The following is our latest Fund Analyst Report for PIMCO StocksPLUS Absolute Return PTOAX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

PIMCO StocksPlus Absolute Return's seasoned management, reasonable fees, and unique structure, which has contributed to its long-term outperformance, merit a Morningstar Analyst Rating upgrade to Bronze from Neutral.

PIMCO capitalizes on its vast bond-investing resources and derivatives-trading capabilities to offer this 2-for-1 fund, which seeks to track the S&P 500 using futures and generate Libor plus 200-300 basis points over a market cycle from an actively managed bond strategy. As the derivatives require only a small cash outlay, it is able to provide about 100% exposure to the performance of both the S&P 500 and the bond portfolio.

Over the long term, low-cost S&P 500 index funds have generated top-quartile performance relative to their large-blend Morningstar Category peers over the trailing 10 years. This fund, with the addition of its active bond portfolio, has been able to outperform these index funds. However, "equity" investors here should note that they are exposed to credit and duration risk, as well as leverage and counterparty risks.

The bond sleeve is in the able hands of Mohsen Fahmi, who has over 30 years of bond-investing experience. He is also a manager at

This fund is cheaper than its average peer, and it would be more expensive to replicate this strategy using an S&P 500 tracker and PIMCO Dynamic Income PDI. Reasonable fees, along with the fund's unique S&P 500 exposure plus a PIMCO-managed bond combination, should provide a performance edge over the long term.

Process Pillar: Neutral | Patricia Oey 08/24/2018 This fund seeks to outperform the S&P 500 by tracking its benchmark (like an index fund) and supplementing returns with an actively managed bond sleeve. For equities exposure, the fund holds S&P 500 futures at a notional value of 100% of the net asset value of the fund. The managers then invest the remaining cash in fixed-income securities, in line with the themes set by PIMCO's investment committee. Mohsen Fahmi can take long and short positions across a broad investment universe, including global credit, rates, and currencies. The goal of the bond sleeve is to generate returns of Libor plus 200-300 basis points over a cycle, before fees.

The process is similar to that of Neutral-rated PIMCO Dynamic Bond, but for this fund, Fahmi is mindful that this bond sleeve sits alongside an equity sleeve. Starting in January 2016, he has been reducing exposure to areas that are more correlated to equities, such as high-yield credit and and negative-duration positioning. He has also implemented more relative value trades with the goal of generating returns that will be uncorrelated with that of equities. There is also more emphasis on the liquidity of the bond portfolio, as equity funds tend to see more-volatile flows relative to a bond fund.

While promising, the process has been a work in progress over the past few years and currently receives a Neutral Process Pillar rating.

About 80% of the fund’s assets are in fixed-income securities, with the remainder in short-term instruments that are used as collateral for the derivatives that provide the fund’s equity and some of its active bond exposures. The bond portfolio has a duration range of negative three years to positive eight years and a maximum exposure of 20% high yield, 25% emerging markets, and 35% non-U.S.-dollar currencies. The portfolio tends to be well below these caps.

For rates, Mohsen Fahmi is concentrated in the United States, as the Fed moves toward normalization, albeit slowly, ahead of other major central banks. Within U.S. government bonds, he is focused on the intermediate portions of the curve. In credit, he tilts toward assets that should benefit from U.S. growth and the improving housing market, such as bank- and housing-related credits. He continues to hold Treasury Inflation-Protected Securities versus nominal Treasuries as he thinks inflation expectations remain low. A notable difference here versus PIMCO Dynamic Bond is Fahmi's much lower exposure to emerging-markets debt and currency, which tends to be correlated with equities. The fund uses derivatives, such as swaps and currency forwards, which come with counterparty, liquidity, and leverage risks, especially in periods of market stress. Equity investors here should also note this fund comes with some duration and credit risk, given its fixed-income holdings.

Performance Pillar: Positive | Patricia Oey 08/24/2018 The fund has generated long-term above-average returns relative to peers. We are upgrading this fund's Performance rating to Positive.

This fund is expected to outperform its S&P 500 benchmark, as its return components are the performance of the index plus the performance of the actively managed bond sleeve. The annual financing cost for the equity exposure has ranged from 3 to 33 basis points during the past four years. This cost, plus the difference in fees (about 60 basis points) between this fund and the cheapest S&P 500 tracker is the hurdle the bond sleeve must exceed.

Over the long term, the fund has succeeded in its goal. Its trailing three-, five-, and 10-year returns through July 2018 (12.9%, 13.5%, and 13.4%) handily outperformed the S&P 500 Index (12.5%, 13.1%, and 10.7%) and the large-blend category average (10.6%, 11.4%, and 9.6%). In all three periods, the fund's performance and risk-adjusted returns were within the top quartile. The trailing three-year return includes a difficult 2015, when the bond strategy detracted about 220 basis points owing to its negative duration as rates fell and its exposure to slumping emerging-markets debt. But in 2016 and 2017, the bond portfolio contributed about 250-350 basis points per year. Securitized mortgage spread positions were the main drivers of performance in those years.

People Pillar: Positive | Patricia Oey 08/24/2018 Mohsen Fahmi is a seasoned investor and is supported by PIMCO's strong investment team. This fund earns a Positive People rating. Fahmi joined PIMCO in August 2014 and one month later took over this fund when Bill Gross left the firm. He is a named manager for PIMCO Dynamic Bond (previously PIMCO Unconstrained), PIMCO Multi Strategy Alternatives PXAAX, and the 14 other PIMCO PLUS equity funds. He is a member of the investment committee, which sets macro guidance for managers across the firm's strategies.

Fahmi had not managed mutual funds before joining PIMCO in 2014, but he does have more than 30 years of bond investing experience. Prior to joining PIMCO, he spent 11 years at hedge fund firm Moore Capital, where he served as chief operating officer for three years and most recently as a portfolio manager for a relative value strategy.

On July 20, 2018, PIMCO added Jing Yang and Bryan Tsu as named managers to this and the other StocksPLUS funds. This followed the departure of prior manager Sudi Mariappa, who moved on to become PIMCO's new global head of risk management. Both Yang and Tsu have been at PIMCO for more than 10 years, focusing on structured credit. As the most senior manager on this fund, Fahmi will retain responsibility for portfolio construction, risk management, and performance. He does not invest in this strategy, but he does invest more than $1 million in PIMCO Dynamic Bond.

Parent Pillar: Positive | 04/06/2017 PIMCO has endured rocky waters, including the late-2014 departure of co-founder Bill Gross. Outflows soared at the firm thereafter but slowed in 2015 and 2016; the firm returned to net inflows in January 2017.

The firm continues to benefit from a standout investment culture. Dan Ivascyn has been successful as comanager of

We have historically taken the firm to task for failing to pass along economies of scale in pricing, but its overall expense profile is reasonable if not notably attractive. That said, PIMCO has never closed a fund to new investors. That is an issue of import given that assets managed in, and using the same strategy as, PIMCO Income grew to more than $100 billion of assets at the end of 2016. We've yet to see evidence drawing a direct line between asset size and performance, but we continue to evaluate the situation.

On balance, PIMCO has many more pluses than minuses and has earned a Positive Parent Pillar Rating.

Price Pillar: Positive | Patricia Oey 08/24/2018 Below-average fees across this fund's share classes justify a Positive Price rating. The fund's I shares account for about 45% of the fund's assets. They have an operating net expense ratio of 0.64%, which is below the 0.75% average of similarly distributed funds. The A shares are the second-largest group, accounting for about 30% of the fund's assets. Its net operating expenses are 1.04%, versus the 1.09% average of similarly distributed peers. Because of the fund's derivatives exposure, its five-year tax-cost ratio of 3.1% is higher than the category average of 1.5%.

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