Bonds Are Different: Resolving the Active Vs. Passive Debate

Bonds are Different: Resolving the Active vs. Passive Debate

More and more investors are turning to passive equity strategies, prompted by evidence that suggests that most active managers have failed to beat their benchmarks. They charge steeper fees too, which sets the bar higher for actively managed funds to outperform. The trend into passive fixed income has also accelerated recently, but while research indicates passive may make sense for stocks, it tells a different story for bonds. Why Bonds Are Different Structural aspects of the bond market combined with changing policies should continue to favor active bond managers over their passive peers.

Why active for bonds? The median active bond manager has outperformed passive alternatives over time, and in various Morningstar categories.

Why does active work in fixed income? The differences between stocks and bonds, including how they trade, create bond-market-specific headwinds for passive strategies – giving active managers more of an edge in fixed income than in equities. Why go active now? Lower expected returns coupled with the Fed’s continuing hiking cycle, makes the flexibility to generate excess returns more important than ever. The median active bond manager has outperformed passive alternatives over time Unlike the median active equity manager, which has underperformed its passive counterpart, the median active bond manager has outperformed the median passive manager by about 50 basis points over the last 10 years. While these gains may not seem substantial, they compound over time and, if sustained, represent meaningful total return potential.

10-YEAR RETURNS OF MEDIAN U.S. ACTIVE AND PASSIVE MANAGERS Active Managers Passive Managers Benchmark¹

8% 14% 12% ) 6% 10.04 10.17

ee s 10% 9.28 f

4.32 e t 8% f

3.72 a

4% 3.53 (

s 6% n r u t 4% 2% e R Returns (after fees) 2% 0% 0% Fixed Income Equity

As of 30 June 2018. Source: Morningstar. Based on Morningstar U.S. Intermediate-Term Bond Category for fixed income and Morningstar U.S. Large Cap Blend Category for equities. Institutional share class. 1 Core Fixed Income: Bloomberg Barclays U.S. Aggregate Index; Core Equity: S&P 500 Index. Morningstar, Inc. is an independent investment research firm that compiles and analyzes fund, stock, and general market data.

Active management has provided attractive excess returns across a range of Morningstar categories

10-YEAR AVERAGE EXCESS RETURN OF ACTIVE FUNDS WITHIN EACH CATEGORY (RELATIVE TO THEIR BENCHMARK) Morningstar Fixed Income categories Morningstar Equity categories 2.5

2.0 1.88

1.5

) 1.02

% 1.0 0.87

( 0.79

r n

u 0.5 0.37 t 0.28 r e

s 0.0 e c -0.09

E x -0.5 -0.24 -0.76 -1.0 -0.89 -1.5 Multisector World Short-Term Intermediate- High Yield Diversiﬁed Foreign Large Large Large Large Bond Bond Bond Term Bond Bond Emerging Mkts Blend Value Blend Growth As of 30 June 2018 . Source: Morningstar Direct. Based on Morningstar U.S. ETF and U.S. Open-End Fund Categories (Institutional shares only). Fee dispersion between active and passive is lower for fixed income While active bond managers charge a higher fee than their passive counterparts, the difference between fees is lower for bonds than for equities. And, for active bond managers, that fee, which is typically used to employ credit research teams and risk analytics professionals, has the potential to pay for itself via higher returns over time.

COMPARISON OF MEDIAN EXPENSE RATIOS (INSTITUTIONAL SHARES ONLY)

Median Active Fee Median Passive Fee 1.4 1.0 1.2 1.0 0.0 0.0 0. 0.8 0. 0. 0. 0. 0.6 0.0 0. ospectus 0.4 P r 0.1 0.0 0.2 0. 0. 0.1 0.0 0. 0.0 0. 0.

Net Expense Ratio (%) 0.0 Intermediate- Short-Term High Yield World Multisector Large Large Large Foreign Large Diversiﬁed Term Bond Bond Bond Bond Bond Blend Growth Value Blend Emerging Mkts

Morningstar Taxable Bond Categories Morningstar Equity Categories

As of 30 June 2018. Source: Morningstar Direct. The four categories in the equity asset class were selected in order to represent the largest AUM categories in each market cap group, as well as the largest non-U.S. category by AUM. Selecting only the categories with the largest AUM would have led to showing only Large Value, Large Blend and Large Growth for the U.S. categories. The difference in fees among large- cap categories is modest. In the fixed income asset class, we show the largest three domestic AUM categories, and the largest non-U.S. category. Fees limited to U.S. open end 40-act mutual funds.

And, the risk/return profile of fixed income benchmarks has become less attractive When yields are low, passive benchmarks can end up taking on more risk (e.g., by increasing duration) without compensating investors. And, in the current interest rate environment, investors are actually taking on more interest rate risk than they have historically taken, while earning a lower yield.

PASSIVE INVESTORS ARE TAKING ON MORE RISK FOR LESS RETURN POTENTIAL Duration (Mod. Adj.) Yield to Maturity 6.5 5% Duration has increased by 2.2 years, 6.0 or about 59%, since 2009. 4% 5.5 Y

s 3% ield r 5.0 e a Y 2% 4.5 Yield has decreased by 0.7%, 4.0 1% or about 17%, since 2009. 3.5 0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 As of 31 October 2018. Source: Barclays, duration and yield statistics represented by Bloomberg Barclays U.S. Aggregate Bond Index. Textbook bond math holds that lower market-wide yields increase the duration of bonds. Some readers will wonder why at certain points – such as the most recent few months – yields and duration have risen together. The explanation is that the average maturity of the index has not remained constant; in fact, it has generally increased over time. On 12/31/2009, average maturity was 6.83 years, on 09/29/2016, it was 7.75 years, and on 12/30/2016, it was 8.19 years. Duration is the measure of a bond's price sensitivity to interest rates and is expressed in years. Lower expected returns make alpha more important than ever Forward-looking returns are closely correlated with today’s yields. By going passive today, your bond portfolio will return approximately today’s yield (less than 4%) on the index, minus fees, annually. By contrast, an active manager may be able to outperform over time, after fees. It’s important to keep in mind that in a low-returning environment, even modest outperformance, which compounds annually, can have a substantial impact on long-term returns.

Bloomberg Barclays U.S. Aggregate Bond Index, yield USD (% yield) Bloomberg Barclays U.S. Aggregate Bond total return, USD forward 10-yr return 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

As of 30 June 2018. Source: Bloomberg, Barclays. Yield and return are for the Bloomberg Barclays U.S. Aggregate Bond Index. Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha.

Passive indexes often exclude attractively valued sectors of the bond market With lower expected returns going forward, access to the broadest possible opportunity set, combined with individual security selection, are key to finding attractively priced securities. Tapping into this broader opportunity set can increase tracking error, so active managers will generally add off-benchmark positions that are modest in size.

SECTOR DECOMPOSITION – GLOBAL FIXED BLOOMBERG BARCLAYS INCOME MARKET U.S. AGGREGATE BOND INDEX

U.S. Treasuries U.S. Treasuries U.S. Securitized EM-Latin America UK U.S. Gov’t related U.S. Gov’t related Other U.S. EM-Asia Japan U.S. IG corporates U.S. IG corporates Other EM Other DM Eurozone U.S. Securitized

As of 31 March 2018. Source: BIS and Haver. Investors should consider the investment objectives, risks, charges and expenses of the Newport Beach Headquarters 650 Newport Center Drive funds carefully before investing. This and other information are contained in the fund's Newport Beach, CA 92660 prospectus and summary prospectus, if available, which may be obtained by contacting +1 949.720.6000 your investment professional or PIMCO representative or by visiting www.pimco.com. Please read them carefully before you invest or send money. A Word About Risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, Hong Kong and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall London as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less Milan than the original cost when redeemed. Munich Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, New York mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The S&P 500 Index is an unmanaged market index generally considered represen- Rio de Janeiro tative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible Singapore to invest directly in an unmanaged index. This material has been distributed for informational purposes only and should not be considered as investment advice or a rec- Sydney ommendation of any particular security, strategy or investment product. No part of this material may be reproduced in any form, Tokyo or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO Toronto PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO. Zurich

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