Navigating U.S. Wealth Management: Five Key Themes for Financial Advisors and Individual Investors

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1 Navigating U.S. Wealth Management: Five Key Themes for Financial Advisors and Individual Investors October 25, 2017 by Eric Mogelof, Barbara Clancy of PIMCO SUMMARY Unprecedented changes are reshaping the financial advice industry and affecting portfolio construction for individual investors. We have observed five key themes based on our discussions with financial intermediaries, advisors and individual investors across the U.S. over the past several months. At PIMCO, we are dedicated to delivering best-in-class investment solutions that can help financial advisors and investors benefit from these industry trends and meet their goals. Unprecedented changes are reshaping the financial advice industry and affecting portfolio construction for individual investors. New regulation, technological innovation, capital market trends and the prospect of lower future returns are all exerting profound effects. At PIMCO, we are dedicated to engaging with our clients to deliver best-in-class investment solutions to help financial advisors and investors benefit from these industry trends and meet their goals. In our discussions with wealth management firms, advisors and individual investors across the U.S. over the past several months, we have observed five key themes. Here is how we see them unfolding and how our partnerships with advisors and individual investors are evolving as a result. THEME ONE: TWO BUSINESS MODELS OF FINANCIAL ADVICE ARE EMERGING TO MEET INVESTOR NEEDS: 1) OUTSOURCED ASSET ALLOCATION/MANAGER SELECTION AND 2) ACCESS AND CUSTOMIZED SOLUTIONS. In perhaps the most immediate development, regulatory pressures and a more complex investment landscape are bifurcating financial advisor business models. One set of advisors is providing more holistic advice, which, in addition to traditional portfolio construction, includes a broader array of services such as estate planning, tax planning and financial coaching, to retain and grow their businesses. With finite resources in a competitive marketplace, many of these advisors are choosing to outsource what was once their primary activity asset allocation and manager selection to home Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 offices and third parties that provide model portfolios and portfolio-construction services. At PIMCO, we have a team of over 25 investment professionals focused on engaging with home offices and model providers to ensure that we are bringing PIMCO s thought leadership and investment capabilities to these financial advisors and their clients. On the other end of the spectrum, we see some advisors catering to the growing number of individual investors seeking highly customized investment portfolios. These advisors embrace the rep as portfolio manager model and focus their time on educating clients on bespoke investment solutions. In addition, these advisors are providing access to unique investment solutions such as alternatives (see theme five) and alternatives beta strategies, differentiating their offering from those of other advisors. To help them, we offer tailored insights and portfolio reviews that leverage PIMCO s proprietary analytics to help differentiate allocations as well as provide highly specialized investment strategies to complement traditional portfolio allocations. Of course, many advisors are straddling both approaches. We are focused on providing solutions that meet the needs of financial advisors as their business models evolve. THEME TWO: DIGITAL TOOLS AND SOLUTIONS ARE CREATING MORE EFFICIENCY AND CUSTOMIZATION. The growing importance of digital tools and solutions in wealth management cannot be overstated. When used appropriately, these solutions enable advisors and investors to solve important financial problems in a highly scaled and efficient manner. Financial advisors and investors are already using technology to automatically rebalance portfolios, monitor risk in real time and create more tax-efficient outcomes. The real value-driver, however, lies in leveraging technology to create highly customized portfolio solutions efficiently. We are focused on developing digital solutions that financial advisors and investors can use to help improve investment outcomes. We recently rolled out our Muni Ladder Portfolio Calculator, which creates customized municipal bond ladder portfolios based upon client criteria in a matter of seconds. We view this as just the tip of the iceberg. We are also converting existing proprietary analytics into digital solutions that can drive dynamic asset allocation. Although the use of digital tools and robo advice can go a long way to delivering client solutions, we think qualitative assessments are crucial. THEME THREE: OUTCOME-ORIENTED SOLUTIONS AND GOALS-BASED INVESTING TAKE CENTER STAGE. Many investors are moving beyond traditional risk tolerance and benchmark-oriented approaches toward outcome- and goals-based investing in which performance is measured by success in meeting specific goals or desired outcomes. These can include generating a consistent and sustainable income stream in retirement; generating sufficient capital appreciation to meet a future spending goal such as paying for education or buying a home; and even ensuring that investments have a positive social impact. By contrast, historical approaches to investing have measured success in terms of outperformance relative to a specific index, or they have measured risk in terms of standard deviation or other volatility metrics. Perhaps the most prevalent example of outcome-based investing is the Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 increased use of income-oriented investment solutions; as baby boomers transition from accumulation to decumulation, financial advisors and investors have increasingly turned to flexible solutions that seek to deliver a certain level of consistent income to meet their needs in the current low-yield environment. At PIMCO, we have created a systematic approach that aims to deliver consistent income along with capital appreciation. Most recently, we launched a series of risk-based retirement income models that focus on delivering a consistent level of income by investing across fixed income and equity markets and aim to deliver yields to help meet retirees spending needs. Investing for income distributions in retirement requires a fundamentally different approach from investing for accumulation before retirement. Retirees today also face unprecedented challenges: the extended period of low yields, the increase in longevity and the shift in responsibility for savings from employer to employee. Combining the growing need for income optimization with a digital approach could create a powerful solution for clients, and this is a focus area for PIMCO. We aim to deliver outcomes for investors through vehicles and solutions that align with their objectives and preferences whether mutual funds, customized separately managed accounts (SMAs), alternatives, model portfolios or digital solutions. We believe outcome-oriented solutions will continue to grow as portfolio construction and asset allocation decisions move toward defining success differently. THEME FOUR: SOPHISTICATED INVESTORS ARE FOCUSING EVEN MORE ON GENERATING CONSISTENT ALPHA GIVEN THE PROSPECTS FOR LOWER RETURNS IN THE YEARS AHEAD. Passive strategies have gained investment flows and market share in recent years as investors look for lower-cost investment solutions to maximize their fee budgets. Active managers that cannot differentiate their solutions are not likely to be successful in this changing landscape. Yet, there is growing recognition that active management can deliver value in certain asset classes, including fixed income. In recent research, PIMCO has found that the median active bond manager has outperformed the median passive manager by about 50 basis points over the last 10 years. 1 A gain like this compounded over time can represent meaningful total return potential. There are many reasons why actively managed bonds can potentially outperform passive: the larger proportion of noneconomic investors in the bond market, the frequency of rebalancing and high turnover in bond benchmarks, the wide range of financial derivatives available, security-level credit research, and new-issue pricing concessions, among others. Equity investors, however, face a dilemma: Returns are expected to be lower going forward, yet active equity managers as a group have not delivered reliable alpha. Fortunately, both passive and active equity strategies have evolved to offer more choice. Rethinking traditional approaches may help investors achieve alpha in equities with greater consistency. Systematic approaches, for example, follow rules-based investment processes that weigh stocks on metrics other than price. Portable alpha approaches, such as PIMCO s StocksPLUS suite, take passive exposure to equities through instruments such as index futures, and then invest in an alpha strategy that seeks to outperform the cost of obtaining that exposure. THEME FIVE: USE OF ALTERNATIVE INVESTMENTS TO ENHANCE PORTFOLIO CONSTRUCTION IS INCREASING. Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 While growth in alternatives was previously driven by institutions, high net worth investors and some mass affluent are now also turning to alternatives, including hedge funds, private equity and interval/closed-end funds, to meet their investment objectives. While the allocation to alternatives by the average individual investor remains below that of institutions, we are seeing greater recognition among individual investors of the role alternatives can play. In a recent report, Cerulli predicted that allocations to alternatives will increase across all channels, with Registered Investment Advisors (RIAs) and wirehouses exhibiting the greatest growth over the next two years at 28% and 17%, respectively. 2 For investors who have the ability to give up some liquidity, and have sufficiently long investment horizons and risk appetite, alternatives can form a critical part of a portfolio, offering attractive riskadjusted returns, diversification benefits and exposure to unique premiums and asset classes. PIMCO has over 15 years of experience managing alternative strategies and $30 billion in alternative assets under management currently across private equity-style and hedge fund vehicles. Our alternatives business focuses on areas that offer compelling opportunities and where we believe we have a demonstrable competitive advantage, such as real estate and mortgages, and private and public credit. LOOKING AHEAD Throughout PIMCO s history, our most successful investment solutions have come through dialogue and collaboration with our clients. We aim to support wealth management firms, advisors and investors through these important changes and look forward to broadening and deepening our partnerships. 1 Source: Morningstar Direct as of 31 December Based on Morningstar U.S. ETF and U.S. Open-End Fund categories, institutional shares only. 2 The Cerulli Report: U.S. Alternative Products and Strategies 2017: The Evolving Search for Risk- Adjusted Returns DISCLOSURES Investors should consider the investment objectives, risks, charges and expenses of the fund carefully before investing. This and other information are contained in the fund s prospectus, which may be obtained by contacting your investment professional or PIMCO representative or by visiting Please read the prospectus carefully before you invest or send money. Past performance is not a guarantee or a reliable indicator of future results. A word about risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, 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 Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 more sensitive and volatile than those with shorter durations; bond prices generally fall 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 than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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. Investing in derivatives could lose more than the amount invested. PIMCO asset allocation models are licensed to investment professionals. The models invest in PIMCO mutual funds and are updated on a defined production cycle. These vehicles are available by prospectus only. Implementing investment professional may or may not implement the model as provided. 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 for a long-term especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. 2017, PIMCO. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.