Arnott on All Asset Sep 2013 PCAAA017

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02 Q&A | SEPTEMBER 2013

Our basic approach boils down to this. Suppose a balanced portfolio ofstocks and bonds can deliver only 2% above ination for the buy-and-hold investor, based on todays prices and yields. We think thats areasonable assumption. If we can add just one percentage point fromeach of the following accessing alternative markets, adding alpha andmanaging the asset mix then were likely to achieve a 5% real returnfor the patient long-term investor. If we can leverage this 5% realreturn at essentially no real cost (as is the case today in PIMCO All AssetAll Authority Fund), then boosting it further to a 6.5% real return stillseems within reach. But these returns wont come comfortably andcertainly not evenly year by year. Theyll require the ability to embracethe maverick risk that comes with a contra-trading approach, mixedwith a certain measure of patience, to exploit rebalancing opportunitiesproperly while complementing that with alpha along the way.

The funds have a large allocation to xed incomestrategies, which has certainly benetted themhistorically as rates have fallen. Looking forward, are

the funds going to be impaired in a secular rising rate regime?

Arnott: Most investors and pundits make the mistake of viewingbonds as a single asset class the bond market, as opposed to theglobal marketplace of bonds, as PIMCOs Tony Crescenzi likes to say.The truth is, the category of bonds spans a huge array of risk-on andrisk-off sectors, ranging from speculative to tame, from nominal toreal, from dollar-based to a basis of almost any currency or collateral

one could care to name. For example, the much-feared secular bearmarket for U.S. bonds has much less to fear in this context. If 10-yearTreasury yields soar because ination expectations loft to 6% or 8%,will Treasury Ination-Protected Securities (TIPS) yields soar or tumble?Will emerging market bond yields soar? How might oating ratebonds perform? Although these markets may exhibit some correlationto each other, the answers are never as simple as one might think.

The broad diversication we see within bonds, including the potential

for some sectors to exhibit low and even negative correlations toTreasuries, is driven by various sources:

1. Credit spreads: Historically, rising interest rates have been metwith tightening credit spreads. Among other factors, this isconsistent with the view weve expressed in the past that risingination reduces the real value of the debt for corporate issuers,resulting in an improvement of debt-servicing capacity.

2. Global interest rates: Global and emerging market rates aredriven by the dynamics in their own markets, which are lesscorrelated to U.S. rates. The diverging impacts of debt anddemography in EM versus the U.S. mean that these dynamics cancontinue to part company.

3. Duration: Whether structurally low-duration (e.g., cash andshort-term) or oating rate (e.g., bank loans), low-duration strategieshave tended to perform reasonably well in rising rate environments.

4. Ination: If interest rate increases are driven by ination, TIPS willtend to outperform. This may not happen immediately, as themarket at rst may boost real rates before placing a premium onthe securities embedded ination protection.

5. Manager skill: Many alternative strategies (e.g., PIMCO CreditAbsolute Return Fund, PIMCO Unconstrained Bond Fund andPIMCO Fundamental Advantage strategies) can actually take on lowto negative duration when PIMCO is sufciently bearish on U.S.bonds, while pursuing other, more alpha-centric sources of return.

In the past, periods of rising mainstream U.S. interest rates, whichhave been decidedly negative for Treasuries and the Barclays U.S.Aggregate Index, have not been punitive to other bond sectors. Ofparticular note are the credit and EM sectors, areas of emphasiswithin the All Asset funds today that historically have seen positivereturns during these same periods, as seen in Figure 1. 4

This is not to say past is always prologue for future performance. Tobe sure, the losses weve seen in the All Asset funds this year have

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Two sources of demonstrated investment expertisePIMCO All Asset funds are supported by the global resources of two industry-leading rms thatwork together closely to pursue the funds objectives.


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SEPTEMBER 2013| Q&A 03

been driven by parallel declines across a broad spectrum of assetclasses following Fed Chairman Ben Bernankes tapering talk. Thereationary forces that underlie the potential for a secular bearmarket in U.S. bonds, however, are less likely to produce the high

correlations that have characterized 2013 thus far.In addition to third pillar assets such as credit strategies and EMequities and debt, the All Asset strategies have an expansiveopportunity set beyond xed income, which can benet investors in arising rate environment. For example, commodities and real estateinvestment trusts (REITs) may offer attractive returns in periods duringwhich ination is driving interest rates higher. Shorting equities alsocan be an important tactic to protect against rising rates, as futurecorporate cash ows and dividends must be priced at a higherdiscount rate, placing downward pressure on valuations. Finally,alternative strategies can help navigate a rising rate environment, too.

For the past few years, Ive been suggesting that the markets willlikely be handing us an opportunity to build an ination hedge on thecheap. Were beginning to see that opportunity now. Althoughination is not assured, should it come, it will not pre-announce.Stocks and bonds, our classic two pillar investment portfolio, crumblein the face of ination. We have time now, over the next months orperhaps a year or two, to dollar-cost-average in building a robust andaggressive third pillar portfolio.

All Asset All Authority Fund has a large allocation to theshort equity strategy. If youre betting that U.S. stockswill go down, wont other markets that you have

holdings in such as EM and credit strategies go down, too?

Arnott: Yes, were mildly bearish on U.S. stocks from these nearall-time-high levels. But that doesnt mean we think U.S. stocks haveto decline in the near term. In fact, our assessment of near-termeconomic strength is somewhat positive. So although we do believe

that over the long term, U.S. stocks are more likely to correct thansoar higher, the majority of our short position is being used to hedgeaway the equity beta of our existing third pillar assets in the portfolio.The portfolios total equity beta is still slightly positive, not negative,net of the short equity strategy.

Assets such as emerging market debt and emerging market equitiesare moving from moderately attractive into bargain territory. Thatdoesnt preclude these markets from getting even cheaper in theshort term, and they can certainly decline further if we see a bearmarket in U.S. stocks. Thats why we are looking to 1) average inslowly, realizing we cant pick market tops and bottoms, and 2) retainample dry powder to pounce if things get really cheap.

Today, though our positioning is defensive with respect to the richestsectors, were at a moderate risk posture overall; were not positionedfor a sharp near-term bear market across risk assets like we were inmid- to late-2008. So if we wake up tomorrow and see the marketsuniversally declining, our portfolio would likely decline in value, too. Iwould expect to fare considerably better on a relative basis, however,than the panoply of mainstream tactical asset allocation programsand balanced funds, against which were often compared. Ourfavorite assets have already been sold off, in some cases somewhatruthlessly, giving us what Ben Graham called a margin of safety something U.S. equities dont have. So although we wouldprobably still incur losses (assuming our current positioning) in a U.S.

0%

Less U.S. duration, morediversied sources of return

A v e r a g e r e t u r n s

d u r i n g t h e

l a s t n i n e r i s i n g r a t e p e r i o

d s

*

Bankloans

8.0%

CreditSpread Tightening has historicallyled to positive returns during risingrate environments

U.S. corePrimary risk factor is U.S. duration, historically leading to negativereturns during rising rate environments

Global and EMGlobal interest rates are driven by the dynamicof each individual market, which may be morefavorable than those in the U.S.

Floatingcredit

Highyield

IG credit U.S. MBS U.S.Treasuries

BarclaysU.S. agg

Long U.S.Treasuries

EMcurrencies

EMlocal bonds

EM externabonds

Globalbonds

U.S. TIPS

Less U.S. duration, morediversied sources of return

6.9% 6.8%

-0.2% -0.2%0.2% 0.3%

-2.9%

-8.3%

7.1%8.5%

-1.3%

10.2%

Figure 1: Credit, global and EM xed income sectors have historically performed well during rising U.S. rate environments*

* Rising rate periods and changes in 10-year Treasuries yield: Dec 91 Mar 92: +83 bps; Aug 93 Nov 94: +246 bps; Dec 95 Aug 96: +137 bps; Sep 98 Jan 00: +225 bps;Oct 01 Mar 02: +116 bps; Jun 05 Jun 06: +122 bps; Dec 08 Jun 09: +132 bps; Sep 10 Mar 11: +96 bps; Apr 13 Jun 13: +81 bps


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PCAAA017_34653

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Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information is contained in each fund's prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative, by visiting pimco.com/investments or by calling 888.87.PIMCO. Please read themcarefully before you invest or send money.Past performance is not a guarantee or a reliable indicator of future results.A word about risk: The funds invest in other PIMCO funds, and performance is subject to underlying investment weightings,which will vary. Investing in thebond market is subject to certain risks, including market, interest rate, issuer, credit andination risk; investments may be worth more or less than the original cost when redeemed. Investing inforeign-denominated and/or -domiciled securities may involve heightened risk due to currency uctuations, and economic andpolitical risks, which may be enhanced in emerging markets.Commodities contain heightened risk, including market, political,regulatory and natural conditions, and may not be suitable for all investors.High yield, lower-rated securities involvegreater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity riskthan portfolios that do not.Equities may decline in value due to both real and perceived general market, economic and industryconditions.Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interestrate, market, credit, management, and the risk that a position could not be closed when most advantageous. 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Leverage, including borrowing, maycause a portfolio to be more volatile than if the portfolio had not been leveraged.The PIMCO short strategy funds are not designed or expected to produce returns that replicate the inverse of the performanceof the applicable index, and the degree of variation could be substantial, particularly over longer time periods. This is due, inpart, to the inverse correlation as well as compounding risk.The PIMCO Global Advantage Bond Index (GLADI) is a diversied global index that covers a wide spectrum of global xedincome opportunities and sectors, from developed to emerging markets, nominal to real assets, and cash to derivativeinstruments. Unlike traditional indices, which are frequently comprised of bonds weighted according to their marketcapitalization, GLADI uses GDP-weighting which puts an emphasis on faster-growing areas of the world and thus makes theindex forward-looking in nature. PIMCOs GLADI methodology is intellectual property covered by U.S. Patent No. 8,306,892.GLOBAL ADVANTAGE and GLADI are trademarks of Pacic Investment Management Company LLC.Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The indexcovers the U.S. investment grade xed rate bond market, with index components for government and corporate securities,mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specic indicesthat are calculated and reported on a regular basis.This material contains the current opinions of the manager, and such opinions are subject to change without notice. Thismaterial has been distributed for informational purposes only and should not be considered as investment advice or arecommendation of any particular security, strategy or investment product. Information contained herein has been obtainedfrom sources believed to be reliable, but not guaranteed. 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1 In addition to pursuing attractive long-term real returns, the strategies also sought to diversify away from stock marketrisk most of the time while seeking better ination protection than mainstream markets.

2 See Robert D. Arnott, Financial Analysts Journal Editors Corner, http://www.cfapubs.org/doi/pdf/10.2469/faj.v62.n2.40763 PIMCO Global Advantage and Research Afliates Fundamental indexes are proprietary, fundamentals-based benchmarks.4 Special thanks to Justin Blesy of the Asset Allocation product team for this analysis

equity bear market, we wouldnt stand idly by if such an eventoccurred. Wed rebalance into the most savaged markets, with ouraggression matching the severity of the sell-off.

This is ultimately how we add value to client portfolios. Minimizinglosses in a bear market only proves fruitful if the portfolio isopportunistically retuned to play offense. Clients would have littleinterest in the All Asset strategies if the relatively tolerabledrawdowns werent followed by absolutely attractive gains inrecovering markets. Staying risk-off following March 2009 or the

summer of 2011 wouldnt have produced interesting returns. Oursuccess in producing a long-term positive experience for our clientswill always depend on the combined performance in the drawdownand bounce-back phases.

Summary:

1. The All Asset funds aim for an outcome of CPI + by pursuingdifferent paths from traditional buy-and-hold 60/40 portfolios.

Among them: accessing alternatives, seeking alpha and tacticallymanaging the asset mix.

2. Investors who fear a secular bear market for U.S. bonds shouldkeep in mind that interest rate sensitivity is only one factor drivingasset prices. The global market of bonds offers skilled managers adiverse array of risk/return opportunities.

3. Third pillar assets such as EM debt and equities are moving intobargain territory, providing the potential for attractive long-termreturns. We are investing slowly while retaining ample dry powderto pounce if they cheapen further.

This Q&A is taken from a recent discussion between RobArnott, portfolio manager and head of Research Afliates,and PIMCO Product Manager John Cavalieri about PIMCOsAll Asset suite and how the funds are being positioned in thecurrent environment.
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Arnott on All Asset Sep 2013 PCAAA017