STRATEGY SPOTLIGHT January 2018 Long/ Equity: Diversification and Risk-Adjusted Returns in an Aging Cycle

AUTHORS Amid an aging equity bull market and after four decades of steadily falling interest rates, equities and bonds alike may be facing an inflection point – and will need to consider all options to optimize future returns. Given the roughly 2.5% yield on the Bloomberg

John M. Devir US Aggregate Bond Index today, equity returns, though Portfolio Manager unlikely to maintain current levels, may still look Long/Short Equity Strategies attractive. PIMCO expects equities to outpace other risk assets again this year. Moreover, while the S&P 500 price/earnings (P/E) ratio of 18x on 2018 earnings estimates is historically high in absolute terms, we think valuations are full but not stretched given current low Benjamin Strom interest rates and healthy earnings growth expectations. Portfolio Manager Long/Short Equity Strategies In light of these realities, we believe the time is right for investors to consider long/short equity strategies, which can play an important role in helping capture the late-cycle benefits of diversification into equities and attractive risk-adjusted performance potential. Historically, long/short equity strategies were primarily available only in the form of funds and limited partnerships. Today, long/short equity strategies have migrated into more easily accessible registered investment vehicles, such as 1940 Act mutual funds. Here we share our views on opportunities in long/short equity and discuss the investment process for PIMCO’s EqS Long/Short Fund. Q: What are the potential benefits of long/short equity strategies in today’s market? A: In what could soon be the second-longest economic expansion in modern history and with markets continuing to grind higher, investors may find that allocating capital into alternative investments, such as well-designed long/short equity strategies, can offer the potential for lower volatility, capital preservation, diversification and enhanced generation given the hedged nature of the product. However, investors need to tread cautiously and fully understand the unique risk profiles of such alternative investments. 2 January 2018 Strategy Spotlight

These strategies can differ PIMCO EqS Long/Short Fund high and only compounded substantially, and significant has maintained a consistent stance by , liquidity and losses have been realized in on equity exposure through much concentration concerns. To this various long/short funds that are of the past 18 months, with a point, the top 10 positions in the still generally correlated to the relatively low risk profile. The Fund represent only about 30% equity market. Fund’s gross and net equity of assets, compared with a 68% Looking over the past 20-plus exposures – which together concentration for the median years, the S&P 500’s compound comprise the overall risk of the long/short in the annual growth rate (CAGR) has portfolio – averaged about 92% prime exceeded that for long/short equity and 42%, respectively, during 2017. brokerage dataset. This compares with average gross strategies. However, the long/short Core positions in the portfolio are and net equity exposures of about equity asset class (as proxied by typically in large, liquid public 232% (or 2.3 times capital) and the Long/Short companies with pristine balance 70%, respectively, for long/short index) has outperformed the S&P sheets, which offers us flexibility to hedge funds (according to 500 in terms of risk-adjusted increase or decrease market prime brokerage returns (measured by Sharpe exposures as needed. We define data through 2017). While long/ ratios) and offered better downside clear catalysts and establish the short equity hedge funds do not protection, as measured by path to realizing returns from each have the constraints or maximum drawdowns (see table). investment by setting explicit price diversification requirements of targets. We strive to avoid Q: What long/short equity a ’40 Act long/short equity fund, permanent losses of capital and solution does PIMCO offer, and we think there is some level of maintain a disciplined risk how is it differentiated from comparability between the two management framework, with other approaches? products in terms of their rigorous testing of downside A: PIMCO’s EqS Long/Short Fund portfolio, management and scenarios before entering a position. risk/return characteristics. This (PMHAX/PMHIX) is a 1940 Act PIMCO EqS Long/Short Fund’s point of differentiation becomes open-end fund for retail and scalable investment process much more important in the later institutional investors that seeks to incorporates PIMCO’s vast innings of an economic expansion, offer investors access to the long- resources and tools – which in our view. term benefits of owning encompass leading economic and while also preserving their capital Our focus on defending against the credit research, bottom-up during extended market declines. downside extends to avoiding financial models and industry data, Fund management focuses on portfolio concentrations (especially and portfolio management and risk sector diversification and in small- or mid-cap companies) management models that have bottom-up equity selection with an and crowded positions, and we been refined over time. We conduct emphasis on owning high quality closely monitor the portfolio’s exhaustive primary research at the businesses with strong credit correlation to equity markets and industry level, including an profiles, while maintaining strict other risk factors. We believe the assessment of secular and cyclical risk management. “cost of being wrong” is already forces, to unearth attractive relative value opportunities. And given the

Long/short equity has outperformed the S&P 500 in terms of risk-adjusted returns

Annualized Monthly Annualized standard Sharpe Maximum correlation Since 1 January 1994 return (%) deviation (%) ratio drawdown (%) versus S&P 500 Credit Suisse Long/Short Equity Index 8.71% 8.99% 0.69 -22.00% 0.67 S&P 500 Index 9.67% 14.42% 0.50 -50.95% N/A Source: Credit Suisse and Bloomberg as of 31 December 2017 January 2018 Strategy Spotlight 3

fund’s focus on investing in high high-profile blow-ups. The heavier cyclicals like machinery quality businesses, our ’s investing framework and and capital equipment, which did process includes a careful focus on owning higher-quality perform well during 2017 but tend consideration of credit quality. master limited partnerships to be more volatile and have lower- We believe that as Warren Buffet (MLPs) versus more cyclical quality balance sheets. famously said, “It’s far better to buy exploration and production Overall, we believe the Fund’s a wonderful company for a fair companies (E&Ps) with weaker performance across diversified price than a fair company at a balance sheets were critical in sectors in 2017 supports our focus wonderful price.” While it’s widely informing our positioning amid on capital preservation and reflects understood that earnings this volatility. our disciplined investment process. predictability is a solid indication Consumer discretionary. The Q: What developments are you of a high quality business, we Morgan Stanley Retail Index watching in long/short equity as believe establishing a high standard (MVRX) was up roughly 2% in we enter 2018? of quality also requires considering 2017 versus a 21% gain for the the macro and secular forces at broader discretionary sector, and A: Looking ahead, we think any work and continually “testing the our investment process, external rise in volatility or even a small moat” around the business. The data monitoring and views on correction in the market could take evolution of equity benchmarks is a secular challenges helped us seek to investors by surprise, given the testament to the reality of generate gains on the short side historically low volatility we’ve persistent economic progress and while avoiding the temptation of seen over the past 12 months and secular change: Recent Morgan buying value traps in the retail what we view as high levels of Stanley research indicates that space. At the same time, we favored complacency. during the last four decades, as positions in cruise lines, housing The key performance risks we’re much as 60%–65% of the companies and lodging/gaming. watching in the hedge fund in the S&P 500 changed over a given Telecom and staples. We avoided segment include a rise in gross and 10-year period. telecom companies with low- net equity exposures and Q: What are some examples of multiple and high-dividend-yield significant position concentrations, your process and active stories by sticking with our along with general investor management of the EqS Long/ fundamental process and attention crowding. We intend to strive to Short Fund in 2017? to what we view as a poor industry defend against these risks by focusing on maintaining a higher- A: The S&P 500 experienced a structure and low earnings quality, liquid portfolio with near 50-percentage-point gap in achievability. We were also prudent use of leverage at this point performance between sectors at underweight staples (which in the aging bull market. times during 2017 (at one point underperformed the market by energy was down roughly 25%, roughly 1,000 bps in 2017) due to In sum, we believe investors while technology was up over our view of challenges to organic seeking diversification, capital 25%), so staying balanced on growth and high valuations. preservation and the potential for our sector views was important Industrials. The Fund maintained enhanced alpha generation in their for performance. Here we provide a material position in rail later-cycle equity investments may examples of our process and operators, which were in our “sweet find PIMCO EqS Long/Short Fund positioning in some key industries spot” as high-barrier-to-entry to offer a credible solution. in 2017: businesses with consistent pricing Energy. The S&P 500 Energy Index power and investment grade was down approximately 4% for ratings. Moreover, our research the year ended 31 December 2017 indicated improving fundamentals despite a 5%–10% rise in crude, and at what we viewed as compelling the sector has been rife with valuations. We generally avoided Investors should consider the investment objectives, risks, charges and expenses of the funds Newport Beach Headquarters carefully before investing. This and other information are contained in the fund’s prospectus 650 Newport Center Drive Newport Beach, CA 92660 and summary prospectus, if available, which may be obtained by contacting your investment +1 949.720.6000 professional or PIMCO representative or by visiting www..com. Please read them carefully before you invest or send money. Past performance is not a guarantee or a reliable indicator of future results. Hong Kong A word about risk: Equities may decline in value due to both real and perceived general market, economic and industry conditions. London Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in securities of smaller capitalization and mid-capitalization Milan companies tend to be more volatile and less liquid than securities of larger companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and Munich political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. High-yield, lower-rated, securities involve greater risk than New York higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in MLPs involves risks that differ from equities, including limited control and limited rights to Rio de Janeiro vote on matters affecting the partnership. MLPs are a partnership organised in the US and are subject to certain tax risks. Conflicts of interest may arise amongst common unit holders, subordinated unit holders and the general partner or Singapore managing member. MLPs may be affected by macro-economic and other factors affecting the in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial Sydney condition, or unfavorable or unanticipated poor performance of a particular issuer. MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow. REITs are subject to risk, such as poor Tokyo performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the Toronto third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be Zurich closed when most advantageous. Investing in derivatives could lose more than the amount invested. The use of leverage 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 Fund is non-diversified, which means that it may invest its investments in a smaller number of pimco.com issuers than a diversified fund. blog.pimco.com There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. 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 , with index components for government and corporate securities, 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. Dow Jones Credit Suisse Long Short Equity Index is an asset-weighted hedge fund index derived from the TASS database of more than 5,000 funds. The directional strategy involves equity oriented investing on both the long and short sides of the market. The objective is not to be . Managers have the ability to shift from the value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional, such as long/short U.S. or European equity, or sector specific, such as long and short technology or healthcare stocks. Long/ Short equity funds tend to build and hold portfolios that are more concentrated than those traditional stock funds. The Morgan Stanley Indexes (Biotech, Retail and Oil Services) consist of large and actively traded stocks that, based on the research of Morgan Stanley Dean Witter, are the leading companies in their respective sectors. Each Index is equal-dollar weighted, meaning that the component securities are represented in approximate equal dollar values. The Indexes are re-balanced quarterly after the close of trading on the third Friday of March, June, September, and December. Index divisors were initially calculated to yield a benchmark value of 100.00 on June 15, 2001. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The S&P 500 Energy Index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector. It is not possible to invest directly in an unmanaged index. This material contains the 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 , 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 is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO. PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO. Investment Products Not FDIC Insured | May Lose Value | Not Guaranteed

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