The All Asset Fund: Seeking Returns When U.S. Markets Are Fully Valued

STRATEGY SPOTLIGHT September 2017 The All Asset Fund: Seeking Returns When U.S. Markets Are Fully Valued AUTHORS Brandon Kunz Asset Allocation Specialist Research Affiliates John Cavalieri Asset Allocation Strategist PIMCO The All Asset Fund has been a powerful return driver and continues to be a diversifying complement to mainstream stocks and bonds. At a time when valuations are rich for many mainstream assets, investors are increasingly looking to tap sources of value and returns outside of these markets. For 15 years, the All Asset Fund has diligently focused on achieving its ambitious long-term return and diversification objectives across varying environments. By tactically allocating across diversifying assets and global stocks and bonds, it has performed in line with its secondary benchmark, Consumer Price Index (CPI) + 5%, which we believe better reflects the longterm objectives of the fund. Using a contrarian approach that emphasizes inflation-sensitive assets, high yield bonds and other credit sectors, and emerging market stocks and bonds, the fund offers a solution to investors seeking tactically managed exposure to diversifying asset classes, while also providing a source of potential returns that complements traditional U.S. equity and fixed income holdings. In this Q&A, Research Affiliates Asset Allocation Specialist Brandon Kunz and PIMCO Asset Allocation Strategist John Cavalieri discuss how the All Asset Fund is favorably positioned to address investors diversification and return-seeking needs over the coming cycle through 1) an attractive starting yield; 2) Research Affiliates ability to flexibly rotate across major liquid global markets; and 3) PIMCO s active management within the underlying strategies. Q: Where can investors find returns, given that U.S. stock and bond markets appear fully valued? Kunz: Investors today face significant challenges when it comes to finding sources of value and prospective returns. A look at starting yields which have historically provided a highly accurate forecast of subsequent returns underscores the declining return potential in mainstream assets. For example, U.S. bonds have exhibited a 92% correlation between current yield and subsequent 10-year returns so if past trends hold, today s yield of 2.5% (as of 31 July) points to similarly low returns over the next decade (see Figure 1).

2 September 2017 Strategy Spotlight Figure 1: Bond returns are tightly correlated to starting yields 16 12 Starting yield Subsequent 10-year nominal return Correlation = 92% Percent (%) 8 4 0 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2017 Source: Research Affiliates based on data from Bloomberg and FactSet as of 31 July 2017. Proxy: Bloomberg Barclays US Aggregate Bond Index. Past performance is not a guarantee or a reliable indicator of future results. For U.S. stocks, the correlation between earnings yield (defined as the ratio of 10-year trailing real earnings per share divided by the current price) and subsequent returns is also strong at 75% (see Figure 2). Unfortunately, equity yields today are lower than at any time other than just before crash of 1929 and the bursting of the tech bubble in 2001. We think investors should expect low U.S. equity returns in the coming decade, and our work suggests a base case of 3% 4% annualized returns, only modestly higher than core bonds ouch! The good news is investors may find significantly higher yields, and thus the potential for higher returns, in diversifying Third Pillar markets, which include real assets, high yield debt and emerging market stocks and bonds. We estimate that an equally weighted basket of these assets may deliver annualized returns of 5.7% over the next five to seven years, or nearly CPI + 4%. Q: The All Asset Fund has delivered strong returns despite changing market conditions over the past 15 years. How does the strategy s design support continued strong returns going forward? Cavalieri: At the All Asset Fund s launch, we set an ambitious secondary benchmark of CPI + 5% and the fund has performed in line with this benchmark not only cumulatively but also during more than 90% of its life, with only brief dips below this level during the two bear market periods (see Figure 3). Considering that this full sinceinception period included the global financial crisis and historically low interest rates, those return results appear even more impressive. Kunz: We believe similar results are achievable going forward, for various reasons. First, the All Asset Fund centers on Third Pillar markets, which we believe are currently priced for elevated return potential. Second, its contrarian investment process tactically elevates exposure to the assets we believe are the most attractively priced; this has increased the fund s current yield meaningfully. Third, PIMCO s active management within the underlying strategies has the potential to deliver additional added value, further bolstering return potential. Putting it all together, we believe the All Asset Fund is poised to deliver compelling return potential both in absolute terms and relative to the traditional U.S. 60/40 balanced approach 1 over the coming cycle. 1 Proxied by the S&P 500 and the Bloomberg Barclays US Aggregate Bond Index.

September 2017 Strategy Spotlight 3 Figure 2: Stock returns look set to decline based on historical yield correlations 18 10-year subsequent return Earnings yield (inverse of CAPE) 25 Correlation = 75% 20 Earnings yield, inverse of CAPE (log scale) 9 5 15 10 5 0 Annualized 10-year subsequent return (%) 2 1926 1937 1948 1959 1970 1981 1992 2003 2014-5 Source: Research Affiliates based on data from Robert Shiller and FactSet as of 31 July 2017. Proxy: S&P 500. CAPE: cyclically adjusted price-to-earnings ratio. PIMCO All Asset Fund S.I. 31 Jul 02 10 yrs. 5 yrs. 3 yrs. 1 yr. 6 mos. 3 mos. Return (after fees) (%) 7.10 5.18 4.24 1.45 10.82 7.04 1.86 Barclays U.S. TIPS: 1-10 Yr Index (%) 4.11 3.57 0.28 0.35-0.26 0.65-0.40 CPI + 5% 7.07 6.66 6.29 5.98 6.87 3.13 0.99 Source: PIMCO as of 30 June 2017. S.I. since inception. Figure 3: The All Asset Fund has delivered on its long-term return goals Growth of $100 $300 280 260 240 220 200 180 160 140 120 100 Jul 02 All Asset Fund versus CPI+5% Jun 03 May 04 Apr 05 Mar 06 Feb 07 Jan 08 PIMCO All Asset Fund CPI+5% CPI Bloomberg Barclays U.S. TIPS: 1-10 Year Index Third Pillar drawdown* Third Pillar bear market* Dec 08 Nov 09 Oct 10 Sep 11 Aug 12 Jul 13 Jun 14 Third Pillar bear market* May 15 Apr 16 Mar 17 Source: PIMCO as of 31 July 2017 Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Investment return and the principal value of an investment will fluctuate. Shares may be worth more or less than original cost when redeemed. Current performance may be lower or higher than performance shown. For performance current to the most recent month-end, visit www.pimco.com or call (888) 87-PIMCO. If this material is used after 30 September 2017, it must be accompanied by the most recent Performance Supplement. For performance to the most recent quarter-end, please visit PIMCO All Asset Fund. Performance is shown for the Institutional share class net of fees. Total expense ratio: 1.065%. * Third Pillar drawdowns are defined as the peak to trough drawdown periods greater than -10% of an equally weighted allocation to U.S. high yield (represented by Barclays U.S. Corporate High Yield Index), Long U.S. TIPS (represented by Barclays U.S. Treasury Inflation Notes: 10+ Year Index), EM local bonds (represented by JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged)), EM equities (represented by MSCI EM Index), REITS (represented by Dow Jones Select U.S. REITs Index.), and Diversified commodities (represented by DJ-UBS Commodity TR Index).

4 September 2017 Strategy Spotlight Q: The All Asset Fund has also delivered strong diversification benefits relative to equities, especially in bear markets. Why should investors consider All Asset as their diversifying return driver over the coming cycle? Cavalieri: Delivering attractive returns is important, but getting those returns from assets that differ from what investors already hold (namely domestic stocks) can be particularly critical if equity returns sputter or, worse still, enter a bear market. The All Asset Fund was built with equity diversification as an explicit goal. Over its 15-year life, the fund has held only 5.1% of U.S. equities on average, with an equity beta (a measure of co-movement) of just 0.39, versus 0.60 for a U.S. 60/40 portfolio. And not only has All Asset provided much-needed diversification in general, it has provided consistent outperformance versus U.S. 60/40 portfolios in both volatile and down markets for U.S. equities just when diversification is needed most. (See Figure 4.) Looking forward, All Asset s potential diversification advantage may prove especially critical for investors seeking continued attractive returns. The extended bull market for U.S. stocks has delivered outsized trailing returns, but forward-looking return prospects are significantly lower given today s full valuations. In contrast, many of the cheaper asset classes that All Asset emphasizes appear poised to lead the next outperformance cycle. Q: Given its real return orientation, the All Asset Fund may be better positioned for rising inflation than traditional 60/40 portfolios. Where do you see inflation headed, and could the All Asset Fund still produce strong returns if inflation remains benign? Kunz: Given the All Asset Fund s focus on real-return-oriented Third Pillar markets, its excess returns are strongly correlated with changes in expected inflation. Historically, All Asset has exhibited roughly 80% correlation with changes in inflation expectations (as represented by U.S. 10-year breakeven inflation over rolling 12-month periods). This has the potential to represent an important return tailwind going forward. The economy is Figure 4: All Asset Fund has outperformed 60/40 portfolios in choppy and down equity markets Low volatility market (Volatility* <= 14.00%) High volatility market (Volatility* > 14.00%) Up market (S&P 500 >= 0.00%) Average rolling 12-month return 12% 10% 8% 6% 4% 2% 0% -2.57 +10.16% +7.59% All Asset Fund 60/40 Average rolling 12-month return 30% 25% 20% 15% 10% 5% 0% +7.85 +25.36% +17.51% All Asset Fund 60/40 2% 0% Down market (S&P 500 < 0.00%) Average rolling 12-month return 1% 0% -1% -2% +1.52% +2.48-0.96% All Asset Fund 60/40 Average rolling 12-month return -5% -10% -15% -20% -11.63% +5.75-17.38% All Asset Fund 60/40 Source: Research Affiliates based on data from FactSet as of 31 July 2017. Based on returns from November 2003 July 2017. The 60/40 portfolio is shown as a representation of a traditional two-pillar diversified portfolio. *Volatility represented by average rolling 12-month volatility of return. Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Investment return and the principal value of an investment will fluctuate. Shares may be worth more or less than original cost when redeemed. Current performance may be lower or higher than performance shown. For performance current to the most recent monthend, visit www.pimco.com or call (888) 87-PIMCO. Performance is shown for the Institutional share class net of fees.

September 2017 Strategy Spotlight 5 now operating above full employment, which should put upward pressure on core services pricing. In addition, the U.S. dollar has depreciated by 9.7% since the beginning of the year, and history and common sense both teach that a weakening currency boosts prices of core goods and services. Should headline inflation expectations eventually rise from today s level of 1.8% toward the Federal Reserve s 2.4% target (the equivalent of 2% personal consumption expenditure (PCE) inflation), we d expect the All Asset Fund to capture additional return potential. Does this mean rising inflation is required for All Asset to produce respectable returns? Not at all. The fund has the flexibility to rotate across major global markets to seek the highest real return potential, regardless of the inflationary regime. Yes, rising inflation provides a natural tailwind, but the fund has historically delivered a strong average rolling 12-month excess return of 5.49% versus 3-month Libor in periods when inflation expectations didn t move by more than a quarter percentage point in either direction over the prior year. Q: How might investors benefit from using the All Asset Fund for their exposure to diversifying assets, rather than doing it themselves? Cavalieri: We believe investors need diversifying investments to complement their core U.S. stock and bond allocations after all, domestic stocks can t always be relied upon to drive high returns. But can investors effectively build a diversified mix of out-ofmainstream, alternative and inflation-sensitive assets for themselves? Of course it s possible, but it presents some practical challenges: Performing adequate due diligence on each of these less conventional markets, and on the various fund managers Determining the optimal asset mix, and adjusting that over time to stay aligned with overall portfolio objectives Explaining the rationale for each allocation decision to (and/or seeking approval from) end-clients or investment committees with varying levels of sophistication The All Asset Fund may present a simpler and more effective solution. Not only is it designed to seek high real returns built on a Typical investor uses of All Asset Diversifying GTAA strategy PIMCO All Asset Fund Liquid alternatives* mix of diversifying Third Pillar markets, but its differentiated return characteristics allow investors to hold it in three typical client buckets : 1. Global tactical asset allocation (GTAA): As a diversifying complement to traditional equity-centric or 60/40 balanced fund approaches 2. Real return: As a multi-asset strategy utilizing a mix of inflation-sensitive assets 3. Liquid alternatives: As a diversifying and flexible strategy that seeks attractive return potential with limited conventional equity market risk The All Asset Fund can thus serve as a potential solution to a range of investors seeking a complementary and diversifying return driver alongside their mainstream stock and bond holdings. Inflation protection / real return strategy *PIMCO s liquid alternative strategies are without the principal lock-ups of traditional private equity funds and hedge funds and include separate accounts whose holdings can be liquidated at a client s request subject to current market conditions, mutual funds that can be liquidated at NAV on a daily basis and ETFs that can be liquidated on the secondary market under normal market conditions. There is no guarantee that a security will be able to be liquidated in a timely fashion or when it would be most advantageous to do so. Refer to Appendix for additional portfolio structure and risk information.

6 September 2017 Strategy Spotlight About the All Asset Fund Three pillars are stronger than two Traditional balanced strategies are built on two pillars: mainstream stocks and bonds. Third Pillar assets can provide higher longterm return potential, help diversify away from traditional stocks and bonds and tend to fare better relative to mainstream assets in inflationary environments. An expert team: PIMCO s active management + Research Affiliates tactical allocation The All Asset Fund delivers two levels of expert management. The underlying funds are managed by PIMCO and benefit from our extensive global resources and time-tested investment process. Asset allocation decisions are managed by Research Affiliates, LLC, a leading tactical allocation firm founded by Robert Arnott. First Pillar Participate in economic growth Seek returns Disinflationary bias Core Stocks Investor Portfolio Core Bonds Diversifiers 1 2 3 Traditional 60/40 allocation Second Pillar Provide income Reduce volatility Disinflationary bias Third Pillar Provide uncorrelated return Seek diversification with income Inflationary bias All Asset

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