All Asset All Access, September 2018

Over the span of All Asset’s life, surviving funds within this second category group delivered on average a return of 5.90% per annum net of fees, a correlation to the S&P 500 of 79.1% and an equity beta of 0.64x. Similarly, the average fund within the Tactical Allocation category, the All Asset Fund’s Morningstar category, delivered an average return of 6.02% per annum net of fees, a correlation to the S&P 500 of 82.9% and an equity beta of 0.57x. Now compare this to a 60/40 portfolio (proxied by 60% S&P 500, 40% Bloomberg Barclays U.S. Aggregate Bond Index), which delivered on average a correlation to the S&P 500 of 98.7% and an equity beta of 0.60x. Isn’t it astounding that, over this horizon, this group of supposedly diversifying funds has on average displayed comparable or more equity risk than a balanced 60/40 portfolio?

In stark contrast, All Asset Fund’s since-inception annualized return, at 6.96% (institutional shares, net of fees) over the same timeframe, is more than 15% and 17% higher than the average fund in the surviving Tactical Allocation and secondary category groups, respectively. All Asset’s beta to the S&P 500 of 0.39x is within the lowest 15th percentile rank versus the secondary category group and within the bottom decile versus the Tactical Allocation category, and its correlation of 61% similarly hovers near or within the bottom decile in both instances. To be sure, All Asset’s historical results may be an indication of why it is used by many investors as a vehicle for diversification. When equities are winning, investors don’t necessarily need for us to shoot the lights out. But when equities are languishing (or worse), investors typically need diversifying sources of return potential. In that context, it is certainly noteworthy that no funds within the Tactical Allocation group and just three across the larger second category group delivered a higher since-inception return at a comparable or lower beta to the S&P 500 than All Asset.

We deliberately aim for All Asset to be a diversifying portfolio. As such, we find it unsurprising that over the full timespan, All Asset Fund’s return per unit of mainstream equity beta has been in the top 7% and top 5% of the Tactical Allocation and secondary category groups, respectively. In bear markets when the S&P 500 was down since All Asset’s inception, All Asset cut the average loss for both surviving category groups by approximately half, with down-market-capture beating 93% and 88% of peers in the Tactical Allocation and secondary category groups, respectively.

How has All Asset All Authority Fund, All Asset’s sister fund, fared relative to its peers since its launch on 31 October 2003? Of the 23 mutual funds classified in the Tactical Allocation category and the 695 funds (598 in Allocation and 97 in Alternatives) in the secondary category group³ that existed at All Authority’s launch, just 18 for the former and a tad over half, or 356, for the latter have survived over this near-15-year span (282 in Allocation and 74 in Alternative). Among these survivors, All Authority’s return per unit of beta over this full span ranks within the highest decile of those peers and within the highest 12th percentile rank of its own category group, Tactical Allocation. Its average return in down markets beats 87% of its peers in the second category group (and 88% for solely Tactical Allocation peers).

Do these comparative outcomes surprise us? Hardly! They are entirely consonant with our mission of seeking to deliver high long-term real returns in a manner that provides investors strong diversification away from mainstream equity risk.

Q: Could you describe your outlook on emerging market (EM) currencies in light of their recent sell-off versus the U.S. dollar?

Kunz: We acknowledge the fear associated with recent predicaments in Argentina and Turkey, and the corresponding spillover effects leading to the pronounced sell-off in a broader basket of EM currencies. While it’s human nature to react swiftly and hit the sell button, a closer look at the countries making up the All Asset funds’ EM currency exposure reveals a different story. As discussed by my colleagues in a recent article,⁴ an examination of external debt, foreign exchange reserves and current account balances points to low risks of a funding crisis for most EM countries – particularly for countries with the largest weights in the underlying PIMCO EM funds across which we tactically manage exposure in the All Asset suite.

In our view, investing in EM currencies (i.e., buying EM currencies and investing in the short-term bills of the constituent countries) offers the highestrisk-adjusted return prospects in all of All Asset’s opportunity set over the next five to seven years. As of 31 July, according to Research Affiliates’ long-term asset class return estimates, we forecast passive exposure to EM currencies (as represented by the J.P. Morgan ELMI index) to offer annualized nominal returns of 5.9% over the coming decade. Among our asset class return estimates, EM currencies trail only the 6.8% offered by EM local bonds (as represented by the J.P. Morgan GBI-EM Index), the 7.0% offered by developed ex U.S. equities (as represented by the MSCI EAFE Index) and the 9.0% offered by unhedged exposure to EM equities (as represented by the MSCI EM Index), all of which share one thing in common: Their currencies trade at discounts, EM in particular, to the U.S. dollar.

Our overall return forecast for EM currencies is driven by a host of individual modeling considerations, not the least of which is the yield of such exposure. As of 31 July, the current yield on passive exposure to EM currencies had risen to 4.6%, more than a percentage point higher than the 3.5% yield available at the end of 2017. Notably though, the exceedingly short duration of this investment renders today’s current yield a less reliable indication of what the average yield will be throughout the longer time horizons over which our return forecasts may be most accurate. It’s for this reason that we at Research Affiliates generate yield forecasts (i.e., equilibrium cash rates for each country) driven by GDP growth prospects, demographic trends, savings preferences and the speed at which central banks move toward equilibrium, among other considerations. After using these inputs to derive forecasts for the average cash rate of each EM country, we then combine them based on the weight of each constituent country within the passive index to derive today’s nominal yield forecast of 4.0% for EM currency exposure.⁵

In addition to creating cash rate forecasts, we also estimate movements in the real exchange rate between countries (i.e., currency valuation changes). For modeling purposes, these forecasts are decomposed into two parts: 1) reversion toward relative purchasing power parity (PPP) and 2) adjustments associated with productivity differentials between countries. On the relative PPP front, and after rolling up country-by-country estimates into the constituent weights of the passive index, EM currencies now trade at a 12.6% discount versus the U.S. dollar (as of 31 July 2018), nearly seven percentage points cheaper than their 5.7% discount versus the U.S. dollar a mere four months prior. Today, if we spread out reversion toward equilibrium PPP over a full decade, EM currencies would stand to appreciate by approximately 1.3% per year. (And continued negative EM currency returns of -3.01% in August, as represented by the JPM ELMI Plus index, only bolster this return potential).

Further EM currency appreciation is possible due to higher relative productivity growth. EM countries have faster-growing populations and younger workforces working up the steeper portion of their learning curves (i.e., undergoing higher productivity growth) than their older developed market counterparts that are closer to peak productivity (i.e., high productivity levels). Historically, higher productivity growth has led to higher real exchange rate appreciation, all else equal. Putting these two components together, we estimate EM currencies are now poised to appreciate by 1.9% per year on top of their already elevated 4.0% yield potential, leading to our all-in return forecast of 5.9% per annum over the coming decade.

We calibrate these longer-term forecasts using shorter-horizon signals from our proprietary business cycle model and momentum considerations, which help inform tactical trading. With recent weakness in EM currency returns, 12-month momentum has now fallen from positive 2.2% at the end of June to negative 0.3% at the end of July. While the magnitude of this negative momentum is not large enough to materially impact our tactical trading, it does decrease our marginal willingness to increase EM currency exposure at this juncture. Offsetting this negative signal on the price momentum front to some degree is the signal from our business cycle model, which continues to indicate modestly below-average probability of economic slowdown for a GDP-weighted aggregation of EM countries (said differently, modestly above-average probability of accelerating GDP relative to recent trend growth). As of the end of July, such slowdown probabilities stood at 43%; while this number is above the recent low of 41% at the beginning of the year, it remains well below its most recent peak of 67% in the third quarter of 2015. Nevertheless, at these levels the business cycle signal today for EM as a whole is not strong enough for us to merit larger tactical trades into procyclical EM currency exposure.

Given these tactical considerations, we remain comfortable maintaining today’s elevated exposure to EM currencies while we wait for stronger signals to justify further buying (or selling). Notably, the All Asset funds also hold tactically elevated exposure to EM local currency bonds and unhedged EM equity strategies, all of which stand poised to benefit from similar return tailwinds should real exchange rates converge toward equilibrium valuations over the coming decade.

Q: How have Research Affiliates’ ongoing research efforts contributed to enhancing the asset allocation process for the All Asset strategies?

Shakernia: The All Asset strategies are driven by a systematic, model-driven allocation process that encodes our core investment belief,⁶ which is that the largest and most persistent active management opportunity is long-horizon mean reversion. A key benefit of using a model-driven process is that it embeds an “emotion-free” discipline to harvest these persistent sources of return, which often requires taking uncomfortable contrarian trades. We seek to diversify away from mainstream assets, take profits from past winners and reallocate into out-of-favor assets, all while accounting for shorter-term price movements.

So are the series of models that drive the All Asset strategies a static, unchanging asset allocation infrastructure; a “set it and forget it” process? Of course not! The asset allocation team at Research Affiliates engages in a continuous process of research toward enhancing our models, refining both our inputs (insights into the capital markets’ expectations of return and risk) and outputs (improvements in the “craftsmanship” of our portfolio implementation). This process involves a thorough assessment of relevant published research across academic and practitioner communities, as well as leveraging the substantial in-house research we conduct at Research Affiliates – much of which we end up publishing as well.

The primary inputs to our asset allocation process are our long-term capital market forecasts.⁷ One area of active research has been on refinements to our expectations of fair value for equities and bonds. We have presented our recent research in this area in several Research Affiliates articles titled the “Holy Grail,”⁸ “CAPE Fear”⁹ and “The Bubble That Never Came.”¹⁰ Our empirical research findings suggest that 1) accounting for macroeconomic volatility helps refine our estimation of equity fair value, 2) CAPE (cyclically adjusted price-to-earnings ratio) is a powerful predictor of long-term market returns, in our opinion; and 3) macroeconomic fundamentals meaningfully drive real interest rates, and as such, low yields do not imply U.S. Treasuries are overvalued. Given that short-term return forecasts always come with wide bands of uncertainty, the modeling benefits from input enhancements tend to be realized over a longer horizon, as compared to the modeling benefits from output enhancements.

Let’s now turn to recent enhancements to the allocation process related to the model output, or our portfolio craftsmanship. Based on research findings, we have included a process of monthly staggered rebalancing within the All Asset strategies in order to complement our longer-horizon mean reversion estimates with shorter-term momentum. Essentially, we create 12 “tranches” of the model and rebalance one-twelfth of the portfolio each month, thus intentionally staggering our trading to target. Intuitively, this process is akin to creating one-year holding periods for each tranche. By extending each tranche’s holding period to one year, we allow recent winners to drift higher in allocation before rebalancing, enabling us to ride momentum: seeking to harvest incremental return from time series momentum¹¹ while also materially reducing strategy turnover.

As before, model enhancements such as these are backed by our investment research findings. This particular example draws from our recent research article, “Hobbled by Benchmarks,”¹² in which we examine a 30-plus-year backtest of a tactical asset allocation process for a broadly diversified universe of 15 major asset classes. We studied the efficacy of tactical asset allocation based on the following components of asset class expected returns: carry (starting yield plus long-term average real income growth) and value (an asset class’s negative trailing-five-year returns). Carry is a proxy for asset class expected returns if valuations stay constant, while value is a proxy for expected returns if valuations mean-revert toward historical norms.

As Figure 2 shows, a staggered rebalancing approach has historically delivered positive excess returns by improving the efficacy of both the carry and valuation signals, with incremental gains peaking at about 12 months. The result is intuitive: The efficacy of tactical asset allocation based on carry and value improves when we slow down the rebalancing frequency (through staggered rebalancing) to better match the long-horizon nature of those signals. Since the All Asset strategies are primarily a valuation-driven investment approach that executes a contrarian philosophy across a similarly broad universe of asset classes, we believe these results are directly applicable: We therefore now include staggered rebalancing into our process in seeking to enhance our tactical allocation performance while also significantly reducing turnover, along with its associated market impact and transactions costs.

The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the sub-advisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.

¹ As an example, in the August 2018 issue, we discussed the concept of sustainable spending income. In previous editions, we’ve shared our thoughts on how All Asset has fared relative to both its official and other applicable benchmarks.

² For the Tactical Allocation and the second category group, we looked at the oldest share class of all U.S.-domiciled funds classified within the broad Morningstar category groups, Allocation and Alternative, with the exception of Target-Date subcategories. Included within the Allocation category is the Tactical Allocation subcategory, which is where the All Asset and All Asset All Authority Funds are classified. Both universes include only surviving funds with available tickers and return data.

³ We use the same criteria as for the analysis of All Asset (e.g., we exclude Target-Date subcategories from the sample, use the oldest share class of each strategy, and focus on only U.S.-domiciled mutual funds).

⁴ Chris Brightman, Michele Mazzoleni and Jonathan Treussard, “Pundits Predicting Panic in Emerging Markets,” Research Affiliates (June 2018).

⁵ For more of an apples-to-apples comparison for our forecasted yield versus current yield, one can adjust the latter downward by our 1.6% relative inflation differential forecast between the U.S. and the EM region (here again represented by the J.P. Morgan ELMI index).

⁶ For details, please read the Research Affiliates paper, “Our Investment Beliefs,” by Chris Brightman, Jonathan Treussard and Jim Masturzo (October 2014).

⁷ The Research Affiliates Asset Allocation Interactive tool specifies long-term return and volatility estimates for a wide range of asset classes.

⁸ Michele Mazzoleni, Omid Shakernia and Michael Aked, “Quest for the Holy Grail: The Fair Value of the Equity Market,” Research Affiliates (March 2017)

⁹ Rob Arnott, Vitali Kalesnik and Jim Masturzo, “CAPE Fear: Why CAPE Naysayers Are Wrong,” Research Affiliates (January 2018)

¹⁰ Michele Mazzoleni and Ashish Garg, “The Bubble That Never Came (and Other Misconceptions about Treasury Bonds),” Research Affiliates (October 2017)

¹¹ Brian Hurst, Yao Hua Ooi and Lasse Heje Pedersen, “A Century of Evidence on Trend-Following Investing,” The Journal of Portfolio Management, 44(1), 15-29 (Fall 2017)

¹² Michael Aked, Rob Arnott, Omid Shakernia and Jonathan Treussard, “Hobbled by Benchmarks,” The Journal of Portfolio Management, 44(2), 74-88 (2018)

DISCLOSURES

Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative or by visiting www.pimco.com. Please read them carefully before you invest or send money.

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

Past performance is not a guarantee or a reliable indicator of future results. The performance figures presented reflect the total return performance for the Institutional Class shares (after fees) and reflect changes in share price and reinvestment of dividend and capital gain distributions. All periods longer than one year are annualized. The minimum initial investment for Institutional class shares is $1 million; however, it may be modified for certain financial intermediaries who submit trades on behalf of eligible investors.

Investments made by a Fund and the results achieved by a Fund are not expected to be the same as those made by any other PIMCO-advised Fund, including those with a similar name, investment objective or policies. A new or smaller Fund’s performance may not represent how the Fund is expected to or may perform in the long-term. New Funds have limited operating histories for investors to evaluate and new and smaller Funds may not attract sufficient assets to achieve investment and trading efficiencies. A Fund may be forced to sell a comparatively large portion of its portfolio to meet significant shareholder redemptions for cash, or hold a comparatively large portion of its portfolio in cash due to significant share purchases for cash, in each case when the Fund otherwise would not seek to do so, which may adversely affect performance.

Differences in the Fund’s performance versus the index and related attribution information with respect to particular categories of securities or individual positions may be attributable, in part, to differences in the pricing methodologies used by the Fund and the index.

There is no assurance that any fund, including any fund that has experienced high or unusual performance for one or more periods, will experience similar levels of performance in the future. High performance is defined as a significant increase in either 1) a fund’s total return in excess of that of the fund’s benchmark between reporting periods or 2) a fund’s total return in excess of the fund’s historical returns between reporting periods. Unusual performance is defined as a significant change in a fund’s performance as compared to one or more previous reporting periods.

A word about risk:

The fund invests in other PIMCO funds and performance is subject to underlying investment weightings which will vary. 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 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. 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. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securitiesinvolve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies. 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. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged. Derivatives and commodity-linked 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. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. The cost of investing in the Fund will generally be higher than the cost of investing in a fund that invests directly in individual stocks and bonds. Diversification does not ensure against loss.

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.

Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods.

The Bloomberg Barclays Global Aggregate (USD Unhedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. Bloomberg Barclays Intermediate Credit Index is the intermediate component of the U.S. Credit Index. The U.S. Credit Index includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements. The Bloomberg Barclays Intermediate U.S. Treasury Index is an unmanaged index representing public obligations of the U.S. Treasury with a remaining maturity of one year or more. Bloomberg Barclays Long-Term Treasury Index consists of U.S. Treasury issues with maturities of 10 or more years. Bloomberg Barclays U.S. Corporate High-Yield Indexthe covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes Emerging Markets debt. Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Bloomberg Barclays 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. Performance data for this index prior to 10/97 represents returns of the Barclays Inflation Notes Index. JPMorgan Emerging Local Markets Index Plus (Unhedged) tracks total returns for local currency-denominated money market instruments in 23 emerging markets countries with at least U.S. $10 billion of external trade. JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged) is a comprehensive global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure. The J.P. Morgan Leveraged Loan Index is designed to mirror the investable universe of U.S. dollar institutional leveraged loans, including U.S. and international borrowers. The J.P. Morgan U.S. Liquid Index is a market-weighted index that measures the performance of the most liquid issues in the investment grade, dollar-denominated corporate bond market. The MSCI EAFE Index is an equity index which captures large and mid cap representation across Developed Markets countries* around the world, excluding the US and Canada. With 928 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. The National Association of Real Estate Investment Trusts(NAREIT) Equity Index is an unmanaged market weighted index of tax qualified REITs listed on the New York Stock Exchange, American Stock Exchange and the NASDAQ National Market System, including dividends. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The S&P GSCI (formerly the Goldman Sachs Commodity Index) serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time. It is a tradable index that is readily available to market participants of the Chicago Mercantile Exchange. It is not possible to invest directly in an unmanaged index.

This material contains the 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. 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. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.

©2018, PIMCO.

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.

CMR2018-0827-351858

© PIMCO

Read more commentaries by PIMCO