PIMCO | Diversified Real Asset Strategy

Diversified Real Asset Strategy

Improving Asset Allocations for Retirement Plans
Individuals and plan sponsors alike face a great deal of uncertainty when determining the optimal asset allocation for retirement savings plans. Traditionally, asset allocations have focused on three key asset classes: stocks, bonds and cash. While stocks and bonds have provided substantial total returns over different historical periods, investors can not afford to simply assume that future returns will match selected historical experience. In addition, when we consider that the macroeconomic conditions that characterized the last 20 to 30 years – persistently declining inflation and interest rates – may be meaningfully different and potentially the opposite of what defines the next few decades, investors may benefit by seeking investments that improve the overall diversification and inflation hedging characteristics of their portfolios. This is relevant particularly in the context of retirement savings, in which individuals often cannot afford a shortfall in the future value of their savings, net of inflation. As the global investment landscape continues to evolve, so too must the asset allocations for retirement savings plans. Diversified Real Asset may play an important role in improving retirement asset allocations by providing the following:

Greater diversification (beyond traditional stocks, bonds and cash)
Improved inflation hedging (holding assets that have positive correlations to inflation)
Enhanced returns potential (using active management to seek potential returns above passive indexes)

What is Diversified Real Asset?

Diversified Real Asset is a strategy intended to serve as a “one-stop” means for gaining strategic exposure to three primary real return assets: Treasury Inflation-Protected Securities (TIPS), commodities, and real estate, providing what PIMCO refers to as its Triple Real^® approach. These asset classes individually and collectively provide important diversification and inflation-hedging benefits to investors:

TIPS – This core real return instrument offers liquidity, low volatility and a government-guaranteed investment, whereby both principal and interest payments adjust to track changes in designated inflation indices
Commodities – This asset class, when measured by an index, historically has provided diversification from virtually any other investment, while also providing a hedge from inflation “surprises” across a wide variety of scenarios
Real Estate – Real estate investment trusts (REITs) provide liquid access to an otherwise illiquid market while also offering historically attractive yield opportunities, returns that track inflation over a secular timeframe, and diversification benefits versus core stocks and bonds

Diversified Real Asset provides actively managed, strategic exposure to these real return asset classes
(Triple Real^® approach) by tracking a benchmark that is comprised of equal one-third weights of the following:

Barclays Capital U.S. TIPS Index
Dow Jones-UBS Commodity Index
Dow Jones U.S. REIT Index

Applications for Diversified Real Asset

Any investor who can benefit from improved diversification and inflation hedging should benefit from a strategic allocation to real assets through Diversified Real Asset. Of particular note are retirement savings plans, including both defined benefit and defined contribution pension plans. Since individual retirement liabilities are real liabilities (in other words, they grow with inflation), there is a clear benefit to broadening the investment opportunity set to include assets that have returns linked to inflation. Diversified Real Asset can serve both as a stand-alone core investment option and as an allocation within an asset allocation strategy. In addition, property and casualty insurance companies, endowments and foundations may find this product attractive as they face multi-year funding requirements that are in real, not nominal, terms.

Investment Philosophy for Diversified Real Asset

Diversified Real Asset, or PIMCO’s Triple Real^® approach, represents a synthesis of PIMCO expertise in managing portfolios dedicated to TIPS, commodities and real estate. In each of these real return asset classes, PIMCO’s approach relies on our longstanding core competency in fixed-income and derivative management. As with all PIMCO portfolios, our investment process incorporates “top-down” global macroeconomic views and “bottom-up” sector-specific views that seek to provide multiple concurrent sources of added value. This process enables PIMCO’s Real Return team to draw from PIMCO’s global macroeconomic forecasting process, sector-specific teams and regional-specific teams in order to optimally structure real return portfolios.

Within Diversified Real Asset we seek to add value within each asset class by outperforming its respective market index, and also by opportunistically tilting the exposures of the asset classes above or below their equal one-third weights. Our strategies for adding value within each asset class include:

TIPS – In TIPS management, we seek to outperform the Barclays Capital U.S. TIPS Index by employing a variety of top-down macroeconomic and bottom-up sector-specific strategies, consistent with our longstanding approach within TIPS portfolios. These strategies include managing real and nominal duration and curve positioning, inflation-related strategies such as “breakeven” and “inflation capture,” country rotation, tactical non-TIPS sector exposure, and security selection among real return issues. In aggregate, these strategies present a robust opportunity set to pursue consistent outperformance versus the Barclays Capital U.S. TIPS Index while maintaining a very high correlation to this passive benchmark.

Commodities – In commodities management, PIMCO uses derivatives linked to commodity indices to gain core exposure to the asset class. This provides exposure to the investment returns of the commodities markets, without investing directly in physical commodities. We fully collateralize those derivatives with fixed-income securities.

We seek to outperform the Dow Jones-UBS Commodity Index by actively managing both our collateral and commodity exposure. Within the collateral, we actively manage an enhanced cash portfolio to outperform the passive three-month T-bill collateral return assumed within the commodity index. Within the commodity exposure, we actively employ structural commodity-based strategies that seek to exploit opportunities within the commodities markets. Examples of these include optimizing the rolling of underlying commodity futures, managing roll yield, and evaluating highly correlated substitute exposures. The combined alpha from actively managing both the collateral and the commodity exposure defines the PIMCO Double Alpha^™ approach that we bring to commodities portfolios.

Real Estate – In real estate management, as in commodities, PIMCO uses derivatives linked to a real estate index to gain basic exposure to the asset class. This provides exposure to the investment returns of the REIT market, without investing directly in individual REIT securities. We seek to outperform the Dow Jones U.S. REIT Index by actively managing an enhanced cash collateral portfolio to outperform the LIBOR-based rate assumed within the derivatives used to gain the core real estate exposure.

In addition to adding value within each of the underlying asset classes, Diversified Real Asset also seeks to add value by employing modest tactical overweights and underweights around the equal one-third exposure to each asset class. The PIMCO portfolio management team regularly performs this relative value assessment and incorporates views on a variety of fundamental, technical, quantitative and economic factors.

PIMCO Real Return Experience

PIMCO has a market-leading real return practice, encompassing portfolios dedicated to inflation-linked bonds, commodities, and real estate. In addition, PIMCO also manages the All Asset strategy, which employs tactical asset allocation with a real return objective across an even wider spectrum of global asset classes. All of these products may help meet investor objectives of achieving consistent after-inflation returns and portfolio diversification over time.

Inflation-linked bond portfolios feature global and regional benchmarks, such as U.S., Euro and U.K. mandates. PIMCO is a recognized market leader in inflation-linked bonds, having launched our flagship inflation-protected securities mutual fund in 1997, just after the U.S. Treasury issued the first TIPS

Commodities portfolios are managed by PIMCO against a variety of published and customized commodity indexes and incorporate a range of underlying collateral strategies and structurally managed commodities-based strategies, which in combination may enhance total returns

Real estate portfolios are benchmarked to an index of REITs that seek to provide returns related to the real estate market

All Asset portfolios combine potential added value by using a broad range of available asset classes, PIMCO management alpha within each asset class, and tactical asset allocation decisions to manage the mix of exposures toward a long-term return that seeks to exceed inflation

Risk Management / Controls

As with all of our specialized strategies, we manage real return portfolios within our core investment philosophies and general portfolio guidelines established by our investment committee. These include limitations on deviations of duration, out-of-index bond exposure, and issue as well as portfolio quality. Additionally, we continuously measure potential price effects from yield-curve movements, premium spread changes, and yield volatility shifts. We manage portfolio characteristics carefully, including any tactical over/underweighting of the component asset classes, so as to avoid large tracking errors, in an attempt to limit underperformance. PIMCO also monitors its counterparties closely, ensuring that they have acceptable credit. We typically settle any derivatives at least once a month, and we exercise normal PIMCO diligence in managing collateral that backs the commodity and REIT index positions.

Real Return Products: Improving Asset Allocations

TIPS, commodities, and real estate display the characteristics of a distinct asset class:

Fundamentally distinct drivers of economic value
Low, even negative, return correlations with other asset classes
Positive correlations to inflation, in contrast to many nominal asset classes

These characteristics have provided opportunities for an improved efficient frontier, while also providing better hedge from the ultimate inflation-related liabilities of retirees.

How To Invest

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. Government securities are backed by the full faith of the issuing government; portfolios that invest in them are not guaranteed and will fluctuate in value. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. The All Asset strategy invests in other PIMCO products and performance is subject to underlying investment weightings which will vary. PIMCO strategies utilize derivatives which 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. Investing in derivatives could lose more than the amount invested. There is no guarantee that this investment strategy will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss.

The Double Alpha™ refers to a strategy that should provide excess return under the active management of collateral backing the commodity index. In addition, this strategy seeks to derive alpha from the structural commodity relative to the index.

The Barclays Capital U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. The Dow Jones UBS Commodity Total Return Index is an unmanaged index composed of futures contracts on 19 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. Dow Jones U.S. Select Real Estate Investment Trust (REIT) Total Return Index, a subset of the Dow Jones U.S. Select Real Estate Securities Total Return Index, is an unmanaged index comprised of U.S. publicly traded Real Estate Investment Trusts. This index was formerly known as the Dow Jones Wilshire REIT Index. It is not possible to invest directly in an unmanaged index.

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.

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