Pacific Investment Management Company LLC’s (PIMCO's) investment products, StocksPLUS, is a unique equity management strategy which offers the potential to outperform the S&P 500 Index, while maintaining a very similar risk level to that of the Index. The StocksPLUS strategy uses stock index futures to achieve non-leveraged stock market exposure and to minimize the risk of underperforming the S&P 500 Index due to adverse stock selection. PIMCO enhances the returns by actively managing a short duration portfolio of fixed income securities backing the futures. We look to consistently add value while minimizing non-market risk. PIMCO has been managing StocksPLUS portfolios for over 12 years.

Uses of StocksPLUS
Clients use StocksPLUS for a variety of purposes. StocksPLUS has historically had a high correlation to the S&P 500 and a standard deviation virtually identical to that of the Index. These characteristics make the approach quite suitable for a core, large capitalization equity component of a client’s asset allocation. At the same time, the excess returns of StocksPLUS have been comparable to those most clients expect from active equity management, but without the large swings in performance relative to the benchmark. In fact, the risk characteristics of StocksPLUS returns are so similar to those of the S&P 500 that it is typically considered an "enhanced index" strategy. In a sense, StocksPLUS represents the best of what passive indexing and active management each attempt to deliver. Proponents of indexing who consider large cap equities an efficient market can take comfort in the fact that, much like a passive index strategy, StocksPLUS captures 100% of the return of the capitalization-weighted S&P 500 Index. However, unlike passive index strategies, StocksPLUS historically provided investors with excess returns of the benchmark derived from a short duration fixed income portfolio that is uncorrelated to the S&P 500. Proponents of active management will be hard pressed to find a large capitalization stock picking strategy that has actually managed to deliver excess of benchmark returns, let alone excess benchmark returns with a level of consistency similar to StocksPLUS. In the ongoing debate over passive versus active management, we feel there is no need to take sides, when a strategy such as StocksPLUS is available. For offshore investors, StocksPLUS offers a significant additional benefit over a traditional stock portfolio (not available through Allianz Global Investors Distributors LLC). Whereas, in many jurisdictions, dividends paid on stock holdings are subject to withholding taxes of between 15% and 30%, the two sources of StocksPLUS returns (S&P futures margin flows and interest income) are generally free from withholding. This added benefit can immediately improve returns over the S&P 500 by quite a few basis points without even taking StocksPLUS excess benchmark returns into account. StocksPLUS investments are available in both separately managed accounts for large portfolios ($100 million and over) and mutual funds.

How Does StocksPLUS Work?
There are essentially two ways to own the S&P 500 index, as illustrated in the accompanying diagram. One can own the 500 stocks that make up the S&P Index. Alternately, one can own an equivalent value of futures on the S&P 500. In both cases the investor receives 100% of the returns provided by the S&P 500 Index. However, an advantage of the futures strategy is that, instead of using the entire cash investment to purchase the physical stocks, an investor only has to post a small margin deposit (currently around 5% of the total contract value) in order to own the futures contracts. This allows the remaining 95% of the initial cash investment to be invested in short-duration interest-bearing securities which back the futures contracts, providing additional reserves to cover potential margin flows stemming from a decline in the value of the S&P 500 Index. The second difference between an investor that holds the physical stocks in the Index and one that holds the futures is that the investor holding the physical stocks receives dividends paid to stockholders while the investor holding the futures contracts must forego these dividends. Both of these differences are taken into account in the pricing of futures contracts. In practice, the futures contract is priced with the embedded assumption that the cash backing the contracts is invested at a short-term interest rate, typically around LIBOR (London Interbank Offered Rate). This is because the bulk of the holders of long S&P futures positions - equity investment managers and index arbitragers - have very short and uncertain time horizons for their holdings of futures, primarily using them as temporary substitutes for physical stocks. Therefore, if PIMCO can invest the cash and consistently achieve returns higher than the embedded short-term rate in the price of S&P 500 Index futures contracts, then StocksPLUS should be able to add value on a consistent basis over the returns of the S&P 500.

Adding Value Through Active, Short Duration Management
The primary means for PIMCO to add value is by actively managing the cash that is backing the S&P 500 Index futures contracts such that the rate of return exceeds that of the short-term interest rate embedded in the pricing of these futures contracts. Our excess benchmark return over this short-term interest rate, which accounts for about 95% of the StocksPLUS historical excess return over the S&P 500 Index, is derived from multiple sources. Importantly, due to the combination of the longer term investment horizon of StocksPLUS investors and our expertise in managing fixed income portfolios at PIMCO, we are not limited to holding only very short-term risk- free assets such as Treasury-bills or other money market instruments. As a result, we are able to expand our opportunity set to include a variety of different high quality securities, such as mortgages, that provide attractive yields and the benefit of diversification. Additionally, from time to time there are opportunities to purchase short-duration foreign bonds, hedge the currency risk, and earn a yield premium over high quality U.S. paper. Such foreign exposure, permitted by Separate Account clients to the extent of about 20% of a StocksPLUS portfolio, serves as a useful means of further diversifying a StocksPLUS portfolio, particularly during the brief periods when the short end of the U.S yield curve inverts

1. The term premium (upward slope in the shape of the yield curve)

2. The transactional liquidity premium (yield which compensates an investor for holding bonds with wider bid/ask spreads) and

3. The credit risk premium.


We believe that the most efficient duration management strategy involves a modest extension of duration beyond the average time to expiration of our futures contracts in order to capture the term premium offered by the positively sloped shape of the yield curve under normal market conditions. Notably, as we limit our portfolio duration to one year, we avoid excessive sensitivity of StocksPLUS returns to changes in interest rates. Thus, the risk related to increasing interest rates is small over time horizons of one year or longer. Except in extreme cases, the higher yield obtained through duration extension and active management should offset any potential decline in the price of the fixed income portfolio due to rising interest rates. The transactional liquidity premium is another structural source of excess returns. If one expects to hold futures indefinitely, after providing sufficient transaction liquidity in reserve to meet the margin flows associated with a stock market crash, the remaining fixed income securities can be invested in higher-yielding, slightly less liquid securities such as CMOs, corporate medium term notes, and other securities. These issues earn a higher yield due to their lower trading liquidity. However, because the securities in this category are short in duration, they are mostly self-liquidating. Thus, market participants who actively trade these bonds in effect subsidize PIMCO's clients who act as long-term holders via StocksPLUS. We can liquidate these holdings if necessary, but typically at a slightly higher transaction cost. Importantly, we generally maintain 50% of the portfolio in securities we feel can be liquidated quickly at minimal cost, thereby ensuring sufficient liquidity to meet margin flows even in a dramatic stock market decline.

Another tool for adding value in StocksPLUS is the credit risk premium obtained by investing in securities with ratings below AAA to capture the yield and diversification benefits while maintaining a high overall portfolio quality. Effective use of these non-Treasury securities such as those offered in the corporate sector adds return to the portfolio with little incremental risk from spread widening (basis risk), given the modest duration of these holdings. While StocksPLUS primarily focuses on the investment grade segment of the corporate bond market, at times we do invest up to 10% of the portfolio in BB-rated securities in Separate Account StocksPLUS portfolios. Importantly, while PIMCO mitigates basis risk by focusing on short duration, high credit quality assets, the modest corporate credit risk in a StocksPLUS portfolio acts to diversify the interest rate or duration risk. This is because an environment of rising short-term rates, where duration exposure would impose a cost on the portfolio, would most likely occur in a strong economic environment when credit risk was diminishing and corporate yield spreads would likely be narrowing. As a result, we generally believe that the use of short duration corporate credits offsets some of the exposure to rising interest rates and further diversifies overall portfolio risk. Overall, an expanded investment opportunity set generally and more specifically these three risk premiums add up to a wide variety of active management opportunities given the combination of PIMCO's broad expertise in the fixed income markets and the longer term holding periods of our investors. The historical excess returns of StocksPLUS are significantly higher than what a passive exposure to these three risk premiums would have delivered in the absence of active management. Notably, for the StocksPLUS strategy to add value, only one of these risk premiums need exist at a given point in time - however, typically each of these three risk premiums exists to a greater or lesser extent. Therefore, the StocksPLUS strategy should be able to add value across many different types of market environments.

Are Futures a Legitimate Proxy for the Stocks in the S&P 500?
S&P futures are an excellent substitute for owning the physical stocks in the index. This relationship holds because, when the index futures contracts expire every quarter, the final price is set equal to the value of the S&P 500 stock index. Although in the short term there can be some deviations between the cash index and the futures, over the long term the structure of the futures contract assures that the futures "track" the stocks. Indeed, one of the major benefits of a futures-based enhanced indexing strategy is that the futures provide 100% of the return of the S&P 500 stocks on a capitalization weighted basis. StocksPLUS seeks to achieve its excess return not by altering the price characteristics of the index but instead by altering the yield characteristics. The magnitude of risk in the yield component of the S&P 500 total return is much less than that of the price component. Therefore, the likelihood of StocksPLUS underperforming the index by a significant degree is, we believe, much lower than the risk in enhanced index strategies that use actual stocks but do not fully replicate the index. The fact that there are times when the futures are not priced at the theoretical equivalent to the stocks provides an additional opportunity to add value. By properly selecting the points at which to "roll" from the current or "nearby" S&P futures contract to one with a more distant expiration date, it has been possible to buy the deferred contracts when they are cheap relative to their theoretical value. The evidence of PIMCO's proven expertise in the futures market is reflected in the returns due to futures in the StocksPLUS portfolios. Since inception, about 5% of the total value added has been attributable to active management of the stock futures contracts. However, going forward we do not expect futures rolling to be as significant a contributor to performance. Rather, we expect the spread between the nearby and the deferred S&P futures contracts to fluctuate within a moderate range of fair value, sometimes adding slightly to our returns and sometimes detracting modestly.