Inflation Response Multi-Asset Strategy Your Global Investment Authority Product Profile September 2011 PIMCO s Asset Allocation Solution for Inflation-Related Investments In an evolving, multi-speed world, there is potential for higher future inflation over the secular horizon relative to what has been the case over the last 30 years. PIMCO believes that investors should always be prepared for the risk of rising inflation, and inflation-related investments, such as inflation-linked bonds, commodities and real estate, offer real, or inflation-adjusted, returns as well as potential diversification benefits relative to typical portfolios without strategic allocations to such assets. While many investors are looking to hedge against this risk, some are contemplating how best to take advantage of an inflationary economic scenario. Solution: Asset Allocation The PIMCO Inflation Response Multi-Asset Strategy is designed to provide a comprehensive portfolio solution for investors seeking diversified exposure to the broad opportunity set of inflation-related investments, including assets that respond to different types of inflation. These include Treasury Inflation- Protected Securities (TIPS), commodities, emerging market (EM) currencies, real estate investment trusts (REITs) and gold. The strategy may also tactically employ floating rate securities in the event of deflation or extreme market shock. PIMCO actively manages the overall asset allocation as well as the
underlying exposures in an effort to enhance returns relative to a static, passive approach. PIMCO also seeks to enhance returns by incorporating tail risk hedging strategies, which are designed to limit the impact of periodic market stresses that may affect inflation-related assets. By combining these potential benefits, the strategy can serve as a compelling comprehensive investment for those seeking to not only hedge inflation, but also potentially benefit from inflation dynamics. Investing in inflation-related assets Many investors look to inflation-related investments as a means to increase the inflation hedging characteristics of their portfolios and to improve diversification vs. investments tied to traditional asset classes such as stocks. Many investors look to inflation-related investments as a means to increase the inflation hedging characteristics of their portfolios and to improve diversification vs. investments tied to traditional asset classes such as stocks, bonds and cash. While stocks and bonds have provided substantial total return potential over different historical periods, past experience may not be a reliable guide to future returns. In addition, the macroeconomic conditions that characterized the last 20 to 30 years including persistently declining inflation and interest rates may be in the midst of meaningful secular shifts that could change the entire investment landscape over the next several decades. In this environment, investors may benefit from improvements in the overall diversification and inflation hedging characteristics of their portfolios. PIMCO s New Normal secular thesis expects the drivers of global growth will shift from developed markets to emerging markets, deleveraging and reregulation will continue to be key themes in the developed markets, and on the margin there will likely be less emphasis on globalization compared with past periods. In turn, we expect that productivity constraints from increased regulatory oversight, higher taxation and nationalization will likely weigh on global growth. Furthermore, we see upward pressure on inflation as the global economy undergoes a shift by emerging markets from exporting disinflation to exporting higher prices. This is likely due to the effect these emerging nations tend to have on commodity prices as well as the likelihood that their currencies may appreciate relative to the U.S. dollar. In addition, wages in some emerging markets are rising, often at a fast pace. We also expect that the buildup of monetary stimulus coupled with the increased velocity of money may result in too much money chasing too few goods. Finally, we see a tolerance by governments for higher inflation in order to maintain low or even negative real borrowing costs (i.e., financial repression) in order to 2
grow out of debt. Given these views, we believe there is a strong likelihood that we will see lower growth in developed countries coupled with higher global inflation potential. Investors are faced with a challenge in determining how best to implement inflation-related investments in their portfolios given that different types of inflation-related assets may respond differently to various types of inflation. For example, in a robust economic recovery where demand for commodities could be strong, commodity-induced inflation pressures could emerge. In such an economic environment, commodities and REITs may be the top-performing inflation-related assets. In contrast, a supply shock that reduces the productive capacity of an economy could lead to low growth coupled with high inflation: It would likely tend to raise prices at the same time that it slows the economy by making production more costly and less profitable. In this scenario, or in any stagflationary environment, TIPS and gold may provide a more favorable inflation hedge. In a multi-speed world of shifting growth and inflation dynamics, we believe investors may benefit from varying their approaches to inflation hedging. The PIMCO Inflation Response Multi-Asset Strategy offers a comprehensive inflation solution, seeking to simultaneously provide inflation hedging characteristics as well as return generation even if inflation stays low. A comprehensive inflation response investment solution The PIMCO Inflation Response Multi-Asset Strategy offers a comprehensive inflation solution, seeking to simultaneously provide inflation hedging characteristics as well as return generation even if inflation stays low. Beyond simply providing exposure to the key inflation-related assets such as TIPS, commodities, EM currencies, REITs and gold the strategy also incorporates three active management approaches: 1. Top-down asset allocation decisions driven by PIMCO s global macroeconomic views, using a risk factor framework. These asset allocation beta decisions are implemented across the range of inflation-related assets in a manner that best achieves PIMCO s risk factor targets. 2. Bottom-up relative value strategies driven by PIMCO s deep expertise in each asset class. These alpha strategies seek to add excess return beyond the asset allocation decisions. Product Profile inflation response multi-asset strategy 3
3. Tail-risk hedging strategies that are incorporated and actively managed in an effort to further increase long-term return potential by seeking to limit losses from periodic market shocks. By combining these elements into a single asset allocation portfolio, the strategy is able to offer investors a comprehensive solution that combines strategic exposure across inflation-related asset classes with a robust risk management return-seeking framework, as outlined in Figure 1. Figure 1: Portfolio Structure Top-Down: PIMCO s Global Macroeconomic Views Asset Allocation Decisions Active Management Alpha INFLATION LINKED BONDS COMMODITIES EM CURRENCY REAL ESTATE GOLD Tail Risk Hedging Portfolio Analytics and Trading Bottom-Up: PIMCO s Real Return Expertise Investment process The investment process for the PIMCO Inflation Response Multi-Asset Strategy builds off the forward-looking views produced by PIMCO s secular and cyclical investment process. This process begins with PIMCO s three- to five-year secular outlook, which identifies key longer-term trends, risks and opportunities across the global economy. It is supplemented by PIMCO s cyclical outlook, which specifies a near-term forecast by assessing drivers and risks to economic growth and inflation in key regions globally. PIMCO s Investment Committee then combines these top-down macro views with bottom-up inputs from the firm s sector and regional specialist portfolio management teams. The result is a series of forward-looking investment views regarding the attractiveness of key global risk factors. PIMCO s Asset Allocation Committee distills these views into risk factor weightings, which can be expressed across and within a range of asset classes. 4
Building off this firm wide process, the portfolio management (PM) team then applies a three-step investment process specific to the strategy: 1. Build the Beta The PM team combines the firm s secular and cyclical investment views with their deep collective inflation expertise to determine the strategy s target asset allocation mix. Specifically, these top-down inputs are used to establish overall risk targets, as well as preferred regions or countries, currencies and commodities. Concurrently, the PM team develops bottom-up views on inflation capture, inflation seasonality, structural commodity trades, interest rates and currencies. These views inform the return forecasts for each underlying asset class by identifying what risk factor within each asset class is likely to drive that return. PIMCO s risk factor framework for asset allocation is a distinguishing approach as it recognizes that risk exposures within asset classes tend to explain the majority of returns, and different combinations of asset classes can provide more effective targeting of desired risk factor exposures, consistent with PIMCO s forward-looking views. Incorporating the Strategy in an Existing Asset Allocation Portfolio Investors can incorporate the PIMCO Inflation Response Multi-Asset Strategy in their existing asset allocation portfolios as a comprehensive inflationrelated asset allocation solution. It can serve as a consolidating strategy for investors who don t want to make individual allocations to the various inflation-related assets, or are looking to replace a static inflation allocation with a dynamic, risk-managed approach. 2. Add the Alpha The PM team also looks to increase excess return potential by incorporating relative value alpha strategies from within each of the underlying inflation-related asset classes. These are incorporated in two ways. First, the PM team will express strategy-specific relative value views within the underlying asset classes in which each specializes. Second, select strategies are enhanced relative to the portfolio level and not the overall asset allocation level, based on the PM team s conviction and the volatility and correlation characteristics of the position relative to the total portfolio. 3. Hedge the Tails As a final step, PIMCO incorporates tail risk hedges, recognizing that risk in financial markets is not normally distributed. The goal is to further increase long-term return potential by limiting losses associated with periodic market stress. By actively managing a mix of portfolio hedges, PIMCO seeks to identify cost-efficient positions that have the potential for outsized gains should certain inflation-related asset classes lose value amid market stress. In addition to mitigating losses, these tail risk hedges may also enable the PM team to acquire additional high quality positions at distressed prices during a crisis, which can further enhance long-term return potential. By combining these three components of the investment process top-down asset allocation, bottom-up alpha strategies, and tail-risk hedging into a comprehensive inflation solution, PIMCO seeks to better manage risk and deliver incremental returns over a passive buy-and-hold investment approach. 5
The tail risk hedging component of the PIMCO Inflation Response Multi-Asset Strategy is designed to provide offensive portfolio hedging. The importance of tail risk hedging Market shocks occur with surprising frequency. Figure 2 provides a list of these major tail risk events that have occurred over the past several decades. Figure 2: Major Financial Crises Since 1980 1982 Latin America Debt Crisis 1987 Black Monday 1989 1991 US S&L Debt Crisis 1992 1993 European Monetary System Crisis 1994 1995 Mexican Peso Crisis 1997 1998 Asian Financial Crisis 1998 Russian Default & LTCM 2001 2002 Argentina Default, dot.com Bust, 9/11 Attacks 2007 2008 Subprime Mortgage Crisis 2008 2009 Global Financial Crisis We believe traditional risk management approaches and pricing models tend to underestimate the frequency and severity of these events, and by extension, their potential detrimental impact on portfolio returns. Investors who fail to account for this investment reality, or who hope to use a just-intime portfolio risk management approach, may find it challenging to achieve their long-term investment objectives. The need for efficient, strategic tail risk management is, we believe, an important pillar for successful investing. The tail risk hedging component of the PIMCO Inflation Response Multi-Asset Strategy is designed to provide offensive portfolio hedging. Not only does it seek to hedge the portfolio from the potentially severe effects of market accidents and policy mistakes, it also helps add exposure to high quality assets that have the potential to be attractively priced as a result of broader market stress. PIMCO evaluates a wide range of extreme scenarios and available tail hedge instruments to determine an optimal hedged portfolio, balancing cost and potential payoff. In so doing, PIMCO s tail risk management strategies can be a critical component for both preserving and enhancing potential portfolio returns over a business cycle. 6 inflation response multi-asset strategy Product Profile
PIMCO Inflation Response Multi-Asset Strategy team Mihir Worah is responsible for integrating PIMCO s investment views and constructing the portfolio, working closely with PIMCO s Asset Allocation Team to ensure alignment with firm wide views and consistency with other PIMCO asset allocation strategies, to the extent applicable. Figure 3: Allocation Decisions Sector specialist views PIMCO Investment Committee views Mohamed El-Erian Asset Allocation, MD, Generalist Portfolio Manager, CEO, Co-CIO Proprietary analytics Vineer Bhansali Asset Allocation and Tail-Risk Hedging, MD, Portfolio Manager, Head of Quantitative Portfolio Strategies PIMCO Asset Allocation Committee Curtis Mewbourne Asset Allocation and Alpha Strategies, MD, Generalist Portfolio Manager For more information, please contact your PIMCO representative or visit pimco.com Portfolio risk parameters Mihir Worah MD, IRMAS Portfolio Manager, Head of Real Return Portfolio Management Portfolio guidelines Stress test/scenario shocks 7
Newport Beach Headquarters 840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000 Amsterdam 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. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and 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. Inflation-linked bonds (ILBs) issued by the various Governments around the world are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Repayment upon maturity of the original principal as adjusted for inflation is guaranteed by the Government that issues them. Neither the current market value of inflation-indexed bonds nor the value a portfolio that invests in ILBs is guaranteed, and either or both may fluctuate. ILBs decline in value when real interest rates rise. In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, ILBs may experience greater losses than other fixed income securities with similar durations. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. 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. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. 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. 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. 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. Statements concerning financial market trends are based on current market conditions, which will fluctuate. 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. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. 2011, PIMCO. Hong Kong London Munich New York Singapore Sydney Tokyo Toronto Zurich pimco.com For institutional investors only PP250-091311