MARKET OVERVIEW Global equities climbed higher last month, despite grumblings that gains were outpacing fun- damentals. The S&P 500 rose 3.6%, its best August performance in nine years and sixth con- secutive monthly advance. From the ashes of early March, the benchmark has soared 53%. Reports showed Japan, Germany, France and at least five other countries officially exited recession in the second quarter. The U.S. manufacturing sector stirred back to life. Invigorated by vehicle sales and the gov- ernment’s “cash for clunkers” program, industrial output rose for the first time since October. Factory gauges for the New York and Philadelphia regions cranked back to pre-recession levels. Americans traded in just under 700,000 gas-guzzling cars and trucks between July 27 and August 24 at a taxpayer cost of $2.9 billion. The impact was evident in July retail sales figures. Although broader spending fell 0.3%, the first decline in three months, receipts at dealerships and parts vendors rose 2.4%. Opposing reports highlighted hope and fear in the housing market. Bulls were encouraged by a 7.2% month-over-month spike in July existing home sales, the largest increase since 1992. Bears noted a record 13.2% of U.S. mortgages were either delinquent or in foreclo- sure in the second quarter. Absent sup- port from Washington, the market would likely be in rougher shape. The Federal Reserve is keeping mortgage rates low by purchasing $1.25 trillion in housing-related debt, while Congress’s $8,000 first-time home buyer tax credit spurs demand. The credit is set to expire November 30. From an earnings standpoint, August was a period of relative calm. Second quarter S&P 500 profit estimates improved mod- estly from -29.5% to -27.3%, according to Thomson Reuters. The third quarter earnings season kicks off October 7 with bellwether aluminum producer, Alcoa. Led by declines in the materials and energy sectors, overall S&P 500 profits are expected to drop 20.8%. The financials sector should do best, with profits bouncing 371% off crisis-ravaged year- over-year comparables. by Greg Meier AUTUMN 2009 A T THE M ARGIN IN THIS ISSUE Market Overview . . . . . . . . .1 Perspective . . . . . . . . . . . . .2 Equity Update . . . . . . . . . . .2 Firm Update . . . . . . . . . . . . .3 Portfolio Manager Insights: Quantitative’s Complementary Role in Portfolios . . . . . . . . . . . . . .4 Feature: The U.S. Federal Reserve — Post-Crisis Policy . . . . . . . . . . . . . . . .6 Focus: Risk Management . . . . . . .8 Chartbook . . . . . . . . . . . . .12 August YTD S&P 500 3.6 15.0 NASDAQ Composite 1.5 27.4 Dow Jones Industrials 3.8 10.6 MSCI EAFE 5.5 24.8 MSCI EAFE Growth 3.2 19.7 MSCI EAFE Value 7.6 30.0 MSCI EM -0.3 51.1 MSCI ACWI xUS 3.7 30.2 MSCI Europe 6.3 26.6 MSCI Japan 3.9 11.3 Russell 1000 3.6 16.4 Russell 1000 Growth 2.1 21.9 Russell 1000 Value 5.2 10.6 Russell Midcap 4.9 25.5 Russell Midcap Growth 3.1 29.7 Russell Midcap Value 6.6 20.8 Russell 2000 2.9 15.8 Russell 2000 Growth 1.0 21.2 Russell 2000 Value 4.7 10.8 ML High Yield Master II 2.0 40.2 As of 31-Aug-09 Market Performance (USD) VOL. 13 NO. 8
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MARKET OVERVIEW
Global equities climbed higher last month, despite grumblings that gains were outpacing fun-
damentals. The S&P 500 rose 3.6%, its best August performance in nine years and sixth con-
secutive monthly advance. From the ashes of early March, the benchmark has soared 53%.
Reports showed Japan, Germany, France and at least five other countries officially exited
recession in the second quarter.
The U.S. manufacturing sector stirred back to life. Invigorated by vehicle sales and the gov-
ernment’s “cash for clunkers” program, industrial output rose for the first time since October.
Factory gauges for the New York and Philadelphia regions cranked back to pre-recession
levels. Americans traded in just under 700,000 gas-guzzling cars and trucks between July 27
and August 24 at a taxpayer cost of $2.9 billion. The impact was evident in July retail sales
figures. Although broader spending fell 0.3%, the first decline in three months, receipts at
dealerships and parts vendors rose 2.4%.
Opposing reports highlighted hope and fear in the housing market. Bulls were encouraged
by a 7.2% month-over-month spike in July existing home sales, the largest increase since
1992. Bears noted a record 13.2% of U.S. mortgages were either delinquent or in foreclo-
sure in the second quarter. Absent sup-
port from Washington, the market would
likely be in rougher shape. The Federal
Reserve is keeping mortgage rates low by
purchasing $1.25 trillion in housing-related
debt, while Congress’s $8,000 first-time
home buyer tax credit spurs demand. The
credit is set to expire November 30.
From an earnings standpoint, August was
a period of relative calm. Second quarter
S&P 500 profit estimates improved mod-
estly from -29.5% to -27.3%, according to
Thomson Reuters. The third quarter
earnings season kicks off October 7 with
bellwether aluminum producer, Alcoa. Led
by declines in the materials and energy
sectors, overall S&P 500 profits are
expected to drop 20.8%. The financials
sector should do best, with profits
bouncing 371% off crisis-ravaged year-
over-year comparables.
by Greg Meier
A U T U M N 2 0 0 9
AT THE MARGIN
IN THIS ISSUE
Market Overview . . . . . . . . .1
Perspective . . . . . . . . . . . . .2
Equity Update . . . . . . . . . . .2
Firm Update . . . . . . . . . . . . .3
Portfolio Manager Insights:
Quantitative’s
Complementary Role in
Portfolios . . . . . . . . . . . . . .4
Feature:
The U.S. Federal
Reserve — Post-Crisis
Policy . . . . . . . . . . . . . . . .6
Focus:
Risk Management . . . . . . .8
Chartbook . . . . . . . . . . . . .12
August YTD
S&P 500 3.6 15.0
NASDAQ Composite 1.5 27.4
Dow Jones Industrials 3.8 10.6
MSCI EAFE 5.5 24.8
MSCI EAFE Growth 3.2 19.7
MSCI EAFE Value 7.6 30.0
MSCI EM -0.3 51.1
MSCI ACWI xUS 3.7 30.2
MSCI Europe 6.3 26.6
MSCI Japan 3.9 11.3
Russell 1000 3.6 16.4
Russell 1000 Growth 2.1 21.9
Russell 1000 Value 5.2 10.6
Russell Midcap 4.9 25.5
Russell Midcap Growth 3.1 29.7
Russell Midcap Value 6.6 20.8
Russell 2000 2.9 15.8
Russell 2000 Growth 1.0 21.2
Russell 2000 Value 4.7 10.8
ML High Yield Master II 2.0 40.2
As of 31-Aug-09
Market Performance (USD)
VOL. 13 NO. 8
PERSPECTIVE
Christopher A.Herrera
Senior Vice President,Portfol io Manager
EQUITY UPDATE
STYLE AND MARKET CAPITALIZATION
Mid-cap stocks were top performers last month.
Mid caps have led just three times in 2009, yet
for the year retain a considerable lead. The
Russell Midcap Index is up 25% since January 1.
That compares with 16% gains in the large-cap
Russell 1000 and small-cap Russell 2000
indexes. From a style standpoint, investors again
favored value over growth in August. Growth
stocks still hold a solid lead for the year.
S&P 500 SECTORS AND INDUSTRIES
Prodigal sons of Wall Street, banks outperformed
again in August. In the past six months, banks
have led the overall market four times, up 137%,
on average, since March 9. Some of the most
beaten-down names have become unlikely star
performers. American International Group, 80%
owned by the U.S. government, returned 245%
last month. Citigroup, 34% government owned,
gained 58%. Both issues are still trading more
than 70% lower than a year ago. Credit crisis-
related losses and writedowns now total $1.6
trillion, according to Bloomberg.
INTERNATIONAL EQUITY
Foreign investors dialed up a second monthly
advance in August, amid fresh signs the Great
Recession was easing. Developed world stocks
captured the lion’s share of gains, bolstered by
strong results in Europe and a falling dollar.
Emerging markets shares trended lower, under-
performing developed markets for the second
time in 2009. Reports showed Japan, Singapore,
Hong Kong, Germany, France, Norway, Thailand
and Israel returned to economic growth in the
second quarter, officially exiting recession.
Chinese shares tipped into a bear market, as a
prime mover behind a local rally — unfettered
bank lending — tightened up.
2
Global equities have rebounded significantly
from the low in March. As of the end of
August, the MSCI All Country World Index
was up 23.6% year to date. The rebound
from the low was driven by a combination of
improving economic news and positive
earnings announcements. Global equities
now trade at 14.6x next twelve month’s
expected earnings, a significant re-rating
from the 9.0x low over the last year.
In aggregate, the positive earnings season
was mostly driven by better-than-expected
cost cutting by companies. Sales growth
was not as prominent a factor in the out-
come versus expectations. In response,
analyst expectations for future earnings
have been revised up significantly over the
last few months. The key to sustaining the
recent rally will be a continued positive
earnings outlook driven by improving eco-
nomic and company-specific fundamentals.
Over the next few months, the market’s
focus will move to the potential recovery in
2010 earnings.
At Nicholas-Applegate, we focus on identi-
fying those companies that are experiencing
positive change that will drive an improve-
ment in their earnings power. In our tradi-
tional global equity portfolios, we favor Asia
ex-Japan equities which benefit from
strength in Chinese demand and improving
domestic economies. In addition, we are
overweight Europe, with an emphasis on
those companies that have a global focus in
their respective businesses. In terms of sec-
tor exposure, we are seeing the most posi-
tive changes in materials and industrial com-
panies. These sectors have high exposure
to demand from emerging markets as well
as positive sensitivity to an expected upturn
in the inventory cycle. As the market's focus
moves from valuation re-rating to earnings
delivery, our focus on bottom-up stock
picking should be an advantage.
Copyright 2009
....Nicholas-Applegate
....Capital Management
FIRM UPDATE
AT THE MARGIN is a
monthly publication of:
Nicholas-Applegate
Capital Management
600 West Broadway
San Diego, CA 92101
PHONE (800) 656-6226
(619) 687-8000
FAX (619) 645-4069
3
This quarter, we welcomed the following professional to our Marketing team:
Clifton A. Wedington — Senior Vice President, Public Funds — Clifton Wedington is respon-
sible for Public Funds marketing on the West Coast. Prior to joining the firm, Clifton was Vice
President, Institutional Advisory Group, with Morgan Stanley Investment Management; Vice
President, Global Wealth Management; Chairman of the Board of Trustees, Contra Costa
County Employees’ Retirement Association; Vice Chairman of the Executive Board of
Directors and Chairman of the Education Committee for the State Association of County
Retirement Systems; and Managing Partner, Computer Audit Systems. He has lectured for
the California Association of Public Retirement Systems conference and the Trustee
Education Program. Clifton earned his B.S. in Business Management from the University of
Maryland, and Certificate in the Advanced Investment Management Program, the Wharton
School, University of Pennsylvania. He has twenty years of investment industry experience.
NICHOLAS-APPLEGATE HOSTS THE MONARCH SCHOOL
On September 8, Nicholas-Applegate hosted the Monarch School at the La Jolla Playhouse
for a student matinee of the play, “The 39 Steps,” an adaptation of Alfred Hitchcock’s 1935
film.The La Jolla Playhouse provided a teaching artist and enrichment guide, which they used
to prepare and engage the students prior to their arrival at the theater. Founded in 1988, the
Monarch School is dedicated to providing homeless and at-risk children with an accredited
education while caring for their basic needs. Today, more than 100 students between the ages
of 7 and 18 are enrolled at the Monarch School. Nicholas-Applegate is a corporate sponsor
of the La Jolla Playhouse.
By Cathleen Bramlage
A scene from the play, "The 39 Steps," produced by the La Jolla Playhouse.
4
Modern portfolio theory stresses the impor-
tance of investment diversification to reduce
portfolio risk and smooth investment returns
throughout various market cycles. The back-
bone of portfolio diversification is investment
in uncorrelated assets, which most typically
includes a blend of fixed income and equity
assets, with those further diversified by
quality and duration in the case of fixed
income, and country, market capitalization,
and style tilt in equities. Beyond these tradi-
tional equity diversifiers, research suggests
that the inclusion of quantitatively managed
strategies as a complement to fundamentally
managed ones also reduces risk and
results in a more efficient total portfolio. The
correlation of excess returns of quantitative
versus fundamental managers over the past
five years has been quite low. Please see
Exhibit 1.
Investors have often shied away from quanti-
tatively managed strategies because their
seemingly complex nature violates one of
Warren Buffett’s top investment principles:
“Never invest in a business you cannot under-
stand.” The reality, however, is that most
quantitative strategies are not managed as
black boxes of fancy math, but rather are
simply formulaic representations of finan-
cial theory, supported
by sound economic
principles. These fac-
tors include meas-
ures such as increas-
ing earnings, positive
guidance by man-
agement, and strong
balance sheet ratios.
Although a formulaic
approach eliminates
the stock story ele-
ment that is often part
of qualitative investing, it also removes the
behavioral and emotional bias of stock selec-
tion in favor of an objective and disciplined
process of risk-controlled investing.
As with all investment styles, quantitative
investing will not always be in favor and fully
rewarded by the market. Indeed, at times in
the investment cycle when sentiment is driv-
ing stock prices, fundamental managers often
are better rewarded than the disciplined,
objective investment process of quant man-
agers due to their process allowing for subjec-
tive adaptations in response to current market
trends. Further, during periods of rapidly
changing information quant managers will
also have difficulty. We’ve experienced such
inflection points twice in the past year, first in
the summer of 2008, then again in the second
quarter of 2009. During these periods of
inflection when, for instance, commodity
prices are falling but earnings estimates
reflect their previous highs, quantitative
models will be at a disadvantage as they
objectively rely on data that fundamental man-
agers are instead able to alter according to
changing information. However, the inverse is
also true, with quantitative managers having a
keen advantage during periods when stock
prices follow a company’s underlying valua-
Blair E. Vaughan, CFA
Product Manager,Systematic
PORTFOLIO MANAGER INSIGHTS: QUANTITATIVE'SCOMPLEMENTARY ROLE IN PORTFOLIOS
Exhibit 1
Correlation of Quantitative vs. Fundamental Active Managers’Excess Returns
US Small Cap Core US Large Cap Core Global Equity
5-year
correlation* 0.45 0.33 0.23
*Quarterly median performance within eVestment asset class universes; Fundamental vs.
Quantitative style is manager-defined; Excess return is the difference between the median
manager return (separate account composite, gross of fees) and the asset class benchmark: US
SCC: Russell 2000; US LCC: S&P 500; Global Equity: MSCI World; Average universe size of man-
agers during the period: US SCC – Fundamental: 71 Quantitative: 41; US LCC – Fundamental: 157
Quantitative: 83; Global Equity – Fundamental: 197 Quantitative: 41.
Source: eVestment Alliance
As of 30-Jun-09
tions, as their models are able to scour the
entire universe for such opportunities effici-
ently and objectively, sometimes identifying a
trend before it has been identified by analysts
who are often the source of ideas for funda-
mental managers. Additionally, we believe that
over the long-term, equity market prices must
trade according to fundamental valuations, and
as such, constructing portfolios according to
such principles in a disciplined fashion will pay
off over a full market cycle.
The past two years have exemplified a period
when quantitative money management styles
have been out of favor, and quant managers
have struggled. According to research pub-
lished by the Research Foundation of CFA
Institute, in 2007, U.S. large-cap quantitative
strategies were the only asset classes to out-
perform their fundamental peers.1 Given this
seemingly long period of underperformance, it
is reasonable to question whether these
returns signal that quantitative management
has lost its advantage. Similar to how funda-
mental managers lagged quantitative ones
through the 2001-2005 period, only to cycle
back into favor, we believe the ability of quants
to produce alpha will return as the market
again consistently trades on underlying com-
pany valuations. This cycle of how the broader
market rewards different investment styles
makes a compelling case for fundamental and
quantitative managers complementing rather
than competing with each other in a client's
portfolio.
5
THE BENEFITS OF QUANTITATIVE INVESTING
Quantitative processes are defined by their objective application of investment principles
across their investment universe. Beyond removing emotional and behavioral biases, these
models inherently lend themselves to sophisticated risk controls and trade-cost management
as part of the portfolio construction process. While fundamental processes necessitate an
allocation of intellectual capital by the portfolio manager, limiting breadth both in universe cov-
erage and portfolio impact due to finite resources, quantitative ones lend themselves to appli-
cation of robust selection criteria across a wide universe. During rational market cycles when
company valuations and stock prices align, a manager’s ability to quickly and efficiently canvass
the entire investment universe for mispricing opportunities is advantageous to clients.
The ability to incorporate risk estimates, including interaction effects with other holdings, and
trading costs into the process maximizes coverage breadth while ensuring a consistent appli-
cation of the investment philosophy. This process lends itself to quantitative managers
having an advantage in customizing and researching specialty mandates according to client