Viewpoint October 2014

Your Global Investment Authority

The Secret of Active Portfolio Management

It seems paradoxical: In theory, active managers in the aggregate should not generate consistent alpha because for one investor to beat the market, another must lag it.i,ii Yet some active managers seem to do better than others – for instance, PIMCO has consistently applied unique insights to seek positive alpha on an after-fee basis for more than 40 years.

In this article we discuss the “structural” or “supersecular” themes that complement PIMCO’s well-known secular and cyclical investment processes. In our opinion, the combination of structural with secular and cyclical analysis is an Mihir P. Worah optimal framework for portfolio management, and it would be extremely Chief Investment Officer Real Return difficult to replicate PIMCO’s long-term success without incorporating this and approach.

In the years ahead, as part of a broader global outlook we have named The New Neutral, we foresee low-single-digit returns for bonds and stocks. Thus, we believe alpha will grow in importance to investors as they seek to achieve their goals. We suggest investors carefully consider the intellectual framework and

investment processes that a manager uses – it is clearly difficult to find the right Ravi K. Mattu Managing Director combination. Global Head of Analytics Structural portfolio tilts or supersecular factors PIMCO was early in identifying five factors in the fixed income markets that historically (on a supersecular basis) have offered attractive risk premiums. Our investment process stresses the importance of constructing portfolios that have structural tilts towards these factors: duration, yield-curve steepeners, credit spreads, volatility sales and liquidity sales. Figure 1 shows the historical returns and volatility of these factors and below we discuss why these would be expected to generate positive returns:

. Duration: This is the basic fixed income risk factor, spread offered on corporate issues has tended to more compensating bondholders who commit capital for an than compensate for historical default rates. The owner extended period of time for uncertainty in future real earns a risk premium for taking default and liquidity risk. interest rates and inflation. Investors are compensated because, in addition to underperformance during economic downturns, . Yield-curve steepeners: Due to investor segmentation, corporate bonds may not be easy to liquidate in these the premium earned for extending maturity has been circumstances. In particular, bonds rated BB have the highest between one- and two-year tenors, and the produced the best returns, as forced selling by indexed lowest between 10- and 30-year tenors. managers often depresses prices to attractive levels. . Option sales: Institutional and individual investors often While Figure 1 does not break out the compensation for purchase overpriced options for hedging or speculative default and liquidity risk, one measure of the liquidity purposes. Selling options as a form of “insurance” on premium is the incremental return of a diversified risky assets has historically provided ample profit portfolio of corporate bonds over an equivalent basket opportunity if scaled appropriately. This can be done of credit default swaps. By this measure, the either explicitly by selling options on interest rates or compensation for liquidity risk in investment grade implicitly by constructing “bulleted” portfolios. corporate bonds has been approximately 35 bps per year . Credit/illiquidity exposure: It is a well-known fact that the over the last decade.

FIGURE 1: PERFORMANCE OF KEY FIXED INCOME FACTORS: JANUARY 1994 TO JUNE 2014

U.S. Treasuries Long-end 1m-10y straddle U.S. IG credit U.S. HY over

over cash steepener sale over Treasuries Treasuries Last 20 years Avg. excess returns (%, p.a.) 2.7 0.7 3.8 0.6 2.9 Volatility (%, p.a.) 4.4 2.1 4.6 4.0 10.1 Sharpe ratio 0.61 0.34 0.83 0.16 0.29 Correlation with S&P 500 -21% -6% 14% 55% 62% Last 10 years Avg. excess returns (%, p.a.) 2.8 0.8 3.9 0.9 4.8 Volatility (%, p.a.) 4.2 2.3 4.4 5.2 11.7 Sharpe ratio 0.67 0.36 0.88 0.18 0.41 Correlation with S&P 500 -30% 5% 26% 64% 75%

Source: PIMCO as of 30 June 2014 PIMCO calculations with data from Barclays, Merrill Lynch and as of 30 June 2014. U.S. Treasuries: Barclays US Treasury Index; Long-end steepener: Excess returns, over cash, of a portfolio that is overweight 1 unit of the Barclays US Treasury 5-10 year index against the Barclays US Treasury 10+ year index on a duration-neutral basis; 1m10y Straddle sale: Rates Theta represents a strategy that sells ATM 1m10y straddles on the 5th, 10th, 15th, 20th and 25th of each month and delta hedges to maturity (using Credit Suisse Indexes) – returns are scaled to match the trailing five-year volatility of the US Treasury index; U.S. IG Credit over Treasuries: Excess returns over duration-matched Treasuries of the Barclays US Credit Index; U.S. HY over Treasuries: Excess returns over duration matched treasuries of the BofA Merrill Lynch US High Yield Index; Computation of excess returns over cash: The cost of funding equals the 1-month OIS swap rate from January 2002 – present. Prior to January 2002, the funding rate equals 1-month LIBOR minus 5 basis points, to account for the long-run historical average credit spread embedded in LIBOR. To compute 1-month excess returns over cash for an asset, we compute its 1-month total return and subtract 1/12-times the beginning-of-period funding rate. Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product.

OCTOBER 2014 | VIEWPOINT 2

Do these structural tilts still hold promise? Investment Committee. These discussions guide active decisions relating to the top-down scaling of exposures to One of the challenges of active portfolio management is various sources of risk premia. In addition, specialist that intellectual capital over time becomes public investment teams in rates, corporate credit, structured knowledge, often even documented in the academic products, real assets and equities provide inputs to our literature. Yet the asset management industry often deliberations. In our view, it would be extremely difficult to ignores these key elements of long-term alpha potential. outperform markets on a sustainable basis without this That said, at current valuations, we expect some of these combination of structural, secular and cyclical analysis (see factors to offer only a modest risk premium over the next Figure 2). decade. We expect structural returns from duration in developed markets and from volatility sales are likely to be FIGURE 2: ESTIMATES OF PROPORTION OF ALPHA ATTRIBUTABLE TO STRUCTURAL TILTS VS. FACTOR TIMING lower than in the recent past, as special factors that AND BOTTOM-UP ALPHA FOR A SAMPLE PIMCO CORE helped duration and option sales – such as the long-term BOND ACCOUNT decline in inflation from the 1980s or large mortgage 100% investors buying interest rate options – are no longer 80% 46% present. On the other hand, we believe expected returns 63% on credit and liquidity should be consistent with historical 60% 74% experience. Furthermore, identifying new, scalable sources 40% of structural risk premia is an integral component of 54% 20% 37% PIMCO’s investment process. In our view, other factors like 26% local currency duration and equity beta in emerging 0% Last 20 years 1994 - 2004 Last 10 years markets (for equity-centric portfolios) are likely to offer % Factor timing and bottom-up alpha attractive risk-adjusted returns. % Alpha due to structural tilts Moving beyond the structural: adding the secular Source: PIMCO as of 30 June 2014. The account above was chosen as it is the largest and the cyclical and most representative of PIMCO’s core bond management. The attribution analysis contained herein is calculated by PIMCO and is intended to provide an estimate as to In addition to the structural tilts that reflect our long-term which elements of a strategy contributed (positively or negatively) to a portfolio's (10+ years) views, the investment process at PIMCO is performance. Attribution analysis is not a precise measure and should not be relied anchored by our annual Secular Forum that looks out upon for investment decisions. three to five years. The cornerstone of our current secular What about equities? view is The New Neutral: the hypothesis that the neutral These structural tilts generally exhibit a low correlation real fed funds rate is likely to be lower than its historical with equity markets and, as such, can be an attractive average. The immediate implication is that the present overlay to equity portfolios as well. A particularly elegant value of all future cash flows and hence the price of all way to incorporate these tilts into the equity markets was financial assets must be higher than previously thought. pioneered by PIMCO in the 1980s under the name This fundamental insight is reflected across PIMCO’s StocksPLUS. This strategy, an implementation of portable portfolios. alpha, uses derivatives to gain exposure to the equity These long-term views are complemented by our cyclical markets, then uses the cash collateral to generate alpha views that look out six to 12 months and are refreshed at potential in the fixed income markets. In fact, last year least three times a year through a formal all-hands-on- Lipper named PIMCO the large company equity manager deck Cyclical Forum, and fine-tuned almost daily by the of the year in the U.S. for the fourth year in a row (2010–

OCTOBER 2014 | VIEWPOINT 3

2013). Conclusions

Equity investors also could benefit from structural tilts to In our view, the adage that it takes active investing to keep systematic factors that are specific to equity markets. the market broadly efficient is still true. Active asset Amongst these, the equity risk premium is the basic factor management is critical to keeping prices anchored to that compensates investors for bearing uncertainty in fundamentals. If the cult of passive investing were taken to economic growth. Option sales on equity indexes and the extreme, and everyone invested in capitalization- investments in less liquid names (small cap) tend to weighted indexes, portfolios would be dominated by the generate positive expected returns just as they do in fixed entities (private or public) that issued the most equity or income. In addition, other systematic factors such as value debt, without any sense of value. (low price/book) and momentum are well-known to be a Active management gains particular importance in this historical source of incremental returns over the broad New Neutral world of muted expected returns across asset equity market. More recently, the attractiveness of classes. Yet one is faced with the conundrum that many exposure to factors such as low versus high volatility and active managers underperform their benchmarks after profitability (quality) also have been noted. The fees. Hence, finding the right active managers with the outperformance potential of these factors can be partly right processes is imperative. We believe this process must attributed to clientele-related factors similar to those in include identifying structural or supersecular sources of fixed income. Some of these structural tilts are return, along with robust macroeconomic and - incorporated in PIMCO strategies based on the level analysis. fundamental indexes developed by Research Affiliates. PIMCO has successfully incorporated this approach for Traditionally, active equity managers have tended to focus more than four decades. solely on name selection. On the other hand, quantitative managers rely only on the structural or systematic factors i Fama, E. and French, K. (2010) “Luck versus skill in the cross- that have outperformed historically – often without an eye section of returns,” Journal of Finance 65 (5), 1915– to valuations. Just as in fixed income, we believe the 1947 ii Chen, Y., Ferson, W. and Peters, H. (2010) “Measuring the optimal approach to long-term outperformance in equities Timing Ability and Performance of Bond Mutual Funds,” Journal combines bottom-up analysis at the security level with of 98(1), 72-89 structural exposure to factors with attractive risk premia.

OCTOBER 2014 | VIEWPOINT 4

Biographies Mr. Worah is CIO Real Return and Asset Allocation and a managing director in the Newport Beach office, a portfolio manager, and head of the real return and multi-asset portfolio management teams. Prior to joining PIMCO in 2001, he was a postdoctoral research associate at the University of California, Berkeley, and the Stanford Linear Accelerator Center, where he built models to explain the difference between matter and anti-matter. In 2012 he co- authored “Intelligent Commodity Indexing,” published by McGraw-Hill. He has 12 years of investment experience and holds a Ph.D. in theoretical physics from the University of Chicago. Mr. Mattu is a managing director and global head of analytics in the Newport Beach office. He oversees portfolio management analytics, client facing analytics and the asset expert team in the Advisory group. Prior to joining PIMCO in 2011, Mr. Mattu was head of research and strategy for Citadel Securities and previously served as Citadel Investment Group’s chief fixed income strategist. Before joining Citadel, he worked at Lehman Brothers for 17 years and held a number of senior positions, including global head of equities and fixed income research, head of quantitative fixed income research and head of securitized product research. He has 32 years of investment experience and holds an MBA from the University of Chicago and a graduate degree from the Indian Institute of Management, Ahmedabad. He received a bachelor’s degree in electrical engineering from GB Pant University in India.

Newport Beach Headquarters 650 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000

Amsterdam

Hong Kong London

Milan

Munich

New York

Rio de Janeiro

Options are not insurance, but may be employed similarly as a hedge against a perceived move in the market (either Singapore up or down). Options are a derivative and are subject to significant risk; see below for additional detail.

Sydney The Lipper Fund Best Group over 3 Years Large Equity award (2010–2013) recognizes funds that have delivered consistently strong risk-adjusted performance, relative to peers Tokyo Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of Toronto 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 as interest Zurich 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. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain .com policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. 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.

This material contains the opinions of the author but not necessarily those of PIMCO 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.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Newport Beach Headquarters Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this 650 Newport Center Drive communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is Newport Beach, CA 92660 authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, +1 949.720.6000 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section Amsterdam 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO Asia Pte Ltd (501 Orchard Road #09-03, Wheelock Place, Singapore 238880, Hong Kong Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not London available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Milan Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of Munich such services and products is unauthorised. | PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, offers services to wholesale clients as defined in the New York Corporations Act 2001. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau Rio de Janeiro (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are Singapore offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in Sydney foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could Tokyo suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment Toronto strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Zurich Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício o Internacional Rio Praia do Flamengo, 154 1 andar, Rio de Janeiro – RJ Brasil 22210-906. | No part of this publication pimco.com 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 Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2014, PIMCO.