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Arnott on All Asset

September 2013
Your Global Investment Authority

Rob Arnott, head of Research A liates, shares his rms market insights and allocation strategies for PIMCO All Asset funds.
Are CPI +5% and CPI +6.5% still relevant benchmarks in the current environment? Arnott: Firstly, CPI +5%/+6.5% is more of a long-term expectation than a benchmark. A proper benchmark ought to be investable. Although most investors would be pleased to invest in an index fund offering an assured CPI +5%, no such fund exists. PIMCO All Asset suite has always been more outcome-oriented in nature. So perhaps a better way to phrase the question is: Are long-term outcomes such as CPI +5% or CP +6.5% plausible from todays opportunity set? I believe the answer is a qualied yes, but it wont be achieved through a buy-and-hold approach focusing on mainstream assets. If we focus on the developed world, were in a low yield, slow growth environment. To think that rising valuation multiples will make up the difference from these lofty starting levels is nave in our view. Bottom-line, most mainstream asset classes simply arent priced to deliver anywhere near these levels of returns, though there are a few outliers value stocks in emerging markets (EM), Europe or Japan come to mind that have reasonable odds of getting there. We would have made a similar assertion back in 2002, however, when PIMCO launched the All Asset family of strategies.1 From the beginning, we saw three paths to help improve investor returns relative to the traditional 60% stock/40% bond-based approach:2 tAccess alternative markets By diversifying more broadly, we expect to nd some markets that are priced to deliver better potential returns because of higher yields, higher growth rates or both. In recent years, we have referred to this as a focus on third pillar assets, distinct from the rst two pillars of mainstream stocks and bonds. Since these assets are often under-owned and poorly understood, they sometimes respond to crises by selling off more sharply than mainstream assets. Ironically, thats one of the beauties of these assets: They give us opportunities to nd better value when mainstream stocks or bonds have been driven rich, as well as periodic opportunities to load up on them at bargain prices when investors are afraid. This maverick risk premium is evident today. tSeek alpha PIMCO has a decades-long history of targeting long-term excess returns, net of fees, across many asset classes and strategies. To be sure, this positive alpha stands in stark contrast to the experience of most active managers and the indexminus-fees return of passive ETFs. In my opinion, its a testament to the people and culture of the rm. We can also aim to produce excess returns by eliminating the return drag (aka negative alpha) embedded in traditional capitalization-weighted indexes, whether through GLADI in bonds or Fundamental Index3 in equities. tManage the asset mix Markets dont always linearly reward risk taking: Sometimes it pays to take on risk and sometimes it doesnt. Risk taking is most rewarding when investors are most fearful and prices have bottomed. Conversely, seeking additional risk is most dangerous following years of rising prices, when investors are most condent and least worried. Ironically, most investors reach for return in the latter circumstances, when they really should be taking risk off the table. To achieve attractive long-term real returns, we need to contra-trade: Look to reduce risk and be willing to accept lower returns when prices are dear so we can mitigate exposure to market corrections and be in a position to re-risk meaningfully at far more attractive levels. In early 2009, in the depths of the global nancial crisis, most assets offered CPI +5% returns, with some far above that level. What a wonderful time to rebalance though precious few investors had the stomach to take on incremental risk back then.

Our basic approach boils down to this. Suppose a balanced portfolio of stocks and bonds can deliver only 2% above ination for the buy-andhold investor, based on todays prices and yields. We think thats a reasonable assumption. If we can add just one percentage point from each of the following accessing alternative markets, adding alpha and managing the asset mix then were likely to achieve a 5% real return for the patient long-term investor. If we can leverage this 5% real return at essentially no real cost (as is the case today in PIMCO All Asset All Authority Fund), then boosting it further to a 6.5% real return still seems within reach. But these returns wont come comfortably and certainly not evenly year by year. Theyll require the ability to embrace the maverick risk that comes with a contra-trading approach, mixed with a certain measure of patience, to exploit rebalancing opportunities properly while complementing that with alpha along the way. The funds have a large allocation to xed income strategies, which has certainly benetted them historically 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 viewing bonds as a single asset class the bond market, as opposed to the global marketplace of bonds, as PIMCOs Tony Crescenzi likes to say. The truth is, the category of bonds spans a huge array of risk-on and risk-off sectors, ranging from speculative to tame, from nominal to real, from dollar-based to a basis of almost any currency or collateral one could care to name. For example, the much-feared secular bear market for U.S. bonds has much less to fear in this context. If 10-year Treasury 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 rate bonds perform? Although these markets may exhibit some correlation to 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 to Treasuries, is driven by various sources: 1. Credit spreads: Historically, rising interest rates have been met with tightening credit spreads. Among other factors, this is consistent with the view weve expressed in the past that rising ination 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 are driven by the dynamics in their own markets, which are less correlated to U.S. rates. The diverging impacts of debt and demography in EM versus the U.S. mean that these dynamics can continue to part company. 3. Duration: Whether structurally low-duration (e.g., cash and short-term) or oating rate (e.g., bank loans), low-duration strategies have tended to perform reasonably well in rising rate environments. 4. Ination: If interest rate increases are driven by ination, TIPS will tend to outperform. This may not happen immediately, as the market at rst may boost real rates before placing a premium on the securities embedded ination protection. 5. Manager skill: Many alternative strategies (e.g., PIMCO Credit Absolute Return Fund, PIMCO Unconstrained Bond Fund and PIMCO Fundamental Advantage strategies) can actually take on low to 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, which have been decidedly negative for Treasuries and the Barclays U.S. Aggregate Index, have not been punitive to other bond sectors. Of particular note are the credit and EM sectors, areas of emphasis within the All Asset funds today that historically have seen positive returns during these same periods, as seen in Figure 1.4 This is not to say past is always prologue for future performance. To be sure, the losses weve seen in the All Asset funds this year have

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Figure 1: Credit, global and EM xed income sectors have historically performed well during rising U.S. rate environments*
Average returns during the last nine rising rate periods* Credit Spread Tightening has historically led to positive returns during rising rate environments
Less U.S. duration, more diversied sources of return

U.S. core Primary risk factor is U.S. duration, historically leading to negative returns during rising rate environments

Global and EM Global interest rates are driven by the dynamics of each individual market, which may be more favorable than those in the U.S.
Less U.S. duration, more diversied sources of return







0.2% 0% -0.2% -2.9% -1.3% -0.2%


Bank loans

Floating credit

High yield

IG credit


U.S. Treasuries

Barclays U.S. agg

-8.3% Long U.S. Treasuries


Global bonds

EM EM EM external currencies local bonds bonds

* 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

been driven by parallel declines across a broad spectrum of asset classes following Fed Chairman Ben Bernankes tapering talk. The reationary forces that underlie the potential for a secular bear market 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 EM equities and debt, the All Asset strategies have an expansive opportunity set beyond xed income, which can benet investors in a rising rate environment. For example, commodities and real estate investment trusts (REITs) may offer attractive returns in periods during which ination is driving interest rates higher. Shorting equities also can be an important tactic to protect against rising rates, as future corporate cash ows and dividends must be priced at a higher discount 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 will likely be handing us an opportunity to build an ination hedge on the cheap. Were beginning to see that opportunity now. Although ination is not assured, should it come, it will not pre-announce. Stocks and bonds, our classic two pillar investment portfolio, crumble in the face of ination. We have time now, over the next months or perhaps a year or two, to dollar-cost-average in building a robust and aggressive third pillar portfolio. All Asset All Authority Fund has a large allocation to the short equity strategy. If youre betting that U.S. stocks will 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 near all-time-high levels. But that doesnt mean we think U.S. stocks have to decline in the near term. In fact, our assessment of near-term economic strength is somewhat positive. So although we do believe that over the long term, U.S. stocks are more likely to correct than soar higher, the majority of our short position is being used to hedge away 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 equities are moving from moderately attractive into bargain territory. That doesnt preclude these markets from getting even cheaper in the short term, and they can certainly decline further if we see a bear market in U.S. stocks. Thats why we are looking to 1) average in slowly, realizing we cant pick market tops and bottoms, and 2) retain ample dry powder to pounce if things get really cheap. Today, though our positioning is defensive with respect to the richest sectors, were at a moderate risk posture overall; were not positioned for a sharp near-term bear market across risk assets like we were in mid- to late-2008. So if we wake up tomorrow and see the markets universally declining, our portfolio would likely decline in value, too. I would expect to fare considerably better on a relative basis, however, than the panoply of mainstream tactical asset allocation programs and balanced funds, against which were often compared. Our favorite assets have already been sold off, in some cases somewhat ruthlessly, giving us what Ben Graham called a margin of safety something U.S. equities dont have. So although we would probably still incur losses (assuming our current positioning) in a U.S.
SEPTEMBER 2013 | Q&A 03

equity bear market, we wouldnt stand idly by if such an event occurred. Wed rebalance into the most savaged markets, with our aggression matching the severity of the sell-off. This is ultimately how we add value to client portfolios. Minimizing losses in a bear market only proves fruitful if the portfolio is opportunistically retuned to play offense. Clients would have little interest in the All Asset strategies if the relatively tolerable drawdowns werent followed by absolutely attractive gains in recovering markets. Staying risk-off following March 2009 or the summer of 2011 wouldnt have produced interesting returns. Our success in producing a long-term positive experience for our clients will always depend on the combined performance in the drawdown and bounce-back phases. Summary: 1. The All Asset funds aim for an outcome of CPI + by pursuing different paths from traditional buy-and-hold 60/40 portfolios.

Among them: accessing alternatives, seeking alpha and tactically managing the asset mix. 2. Investors who fear a secular bear market for U.S. bonds should keep in mind that interest rate sensitivity is only one factor driving asset prices. The global market of bonds offers skilled managers a diverse array of risk/return opportunities. 3. Third pillar assets such as EM debt and equities are moving into bargain territory, providing the potential for attractive long-term returns. We are investing slowly while retaining ample dry powder to pounce if they cheapen further. This Q&A is taken from a recent discussion between Rob Arnott, portfolio manager and head of Research Afliates, and PIMCO Product Manager John Cavalieri about PIMCOs All Asset suite and how the funds are being positioned in the current environment.

In addition to pursuing attractive long-term real returns, the strategies also sought to diversify away from stock market risk most of the time while seeking better ination protection than mainstream markets. 2 See Robert D. Arnott, Financial Analysts Journal Editors Corner, 3 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

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 or by calling 888.87.PIMCO. Please read them carefully 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 the bond market is subject to certain risks, including market, interest rate, issuer, credit and ination risk; investments may be worth more or less than the original cost when redeemed. Investing in foreigndenominated and/or -domiciled securities may involve heightened risk due to currency uctuations, and economic and political 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 involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management, and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, oods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. The cost of investing in the funds will generally be higher than the cost of investing in funds that invest directly in individual stocks and bonds. The funds are non-diversied, which means that they may invest their assets in a smaller number of issuers than a diversied fund. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies. PIMCO All Asset All Authority Fund utilizes leverage, which may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause 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 performance of the applicable index, and the degree of variation could be substantial, particularly over longer time periods. This is due, in part, 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 xed income opportunities and sectors, from developed to emerging markets, nominal to real assets, and cash to derivative instruments. Unlike traditional indices, which are frequently comprised of bonds weighted according to their market capitalization, GLADI uses GDP-weighting which puts an emphasis on faster-growing areas of the world and thus makes the index 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 index covers 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 indices that 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. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacic Investment Management Company LLC, respectively, in the United States and throughout the world. 2013 PIMCO PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY 10019, is a company of PIMCO.

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