PIMCO has always believed actively managed bond portfolios should provide returns over and above those of passively managed portfolios, particularly over the longer term.

PIMCO has identified three specific reasons why active management strategies are likely to produce higher returns than passive strategies, with limited changes to overall portfolio risk:

• Bond Market Inefficiencies: Inefficiencies in the bond market, often the result of restrictions on passive strategies, provide both structural and tactical opportunities to generate returns that should exceed those of benchmark indices.
• Diverse Sources of Added Value: Active managers with extensive resources and expertise across all sectors of the market can identify many small and diverse sources of added value, which should boost returns on a consistent basis without significantly altering risk levels. This philosophy is embedded in PIMCO’s approach to core active management.
• Passive Management Limitations: Passive strategies often sacrifice return because of restrictions on the securities they can invest in, while a structural tilt toward higher-yielding issues can add unexpected risks that most passive managers lack the resources to evaluate.

Bond Market Inefficiencies = Structural and Tactical Opportunities
In contrast to the equity market where structural inefficiencies are less pronounced, the bond market offers ample structural inefficiencies for an active manager to exploit. Tactical opportunities to add value are equally plentiful, particularly when market sentiment turns excessively negative or positive. These opportunities are not always obvious to those with a short-term investment horizon. But a resourceful active manager, with a three- to five-year time horizon, can exploit inefficiencies and excesses in many small ways that not only provide consistent performance but also help to maintain a level of risk similar to the underlying benchmark.

PIMCO believes there is a significant distinction between “core” and “non-core” active management. PIMCO’s active management philosophy is to identify as many opportunities as possible to add value relative to the benchmark. We consider this a “core” approach because we diversify our sources of excess return by taking many small deviations from the benchmark index, rather than one or two large positions, a “non-core” approach, which can cause a significant divergence between portfolio and index returns. We believe our approach is far better suited to core fixed-income allocations because it tends to track the targeted index while attempting to provide enhanced returns, helping to ensure that our actively managed portfolios perform as expected relative to other markets and asset classes and do not include aggressive positions that might skew those relationships.

The fixed income market includes a wide variety of securities, from nominal and real-return Treasuries and mortgage-backed securities to bonds from corporate and emerging market issuers. Each sector has its own distinct risk and return characteristics. The degree of inefficiency varies from sector to sector as well. Active managers with access to the full spectrum of fixed income securities have a much broader opportunity set than passive strategies, which are limited by the index, not only for seeking additional returns but for diversifying risks as well.

Structural Opportunities to Add Value
Many of the bond market’s structural inefficiencies result from the fact that some of the market’s largest participants have different investment objectives and are restricted, or restrict themselves, in various ways. These “clientele effects” can create pockets of value where demand is artificially suppressed. This contrasts with the greater focus in the equity market on wealth creation with fewer parameters. Additionally, bond market investors with a shorter investment and performance time horizon than PIMCO can distort prices over the short term, creating opportunities to capture long-term value.

PIMCO has identified four specific structural aspects of the bond market that commonly allow the active manager to provide more return than passively managed portfolios:

• Term Premiums: The front-end of the yield curve offers a number of opportunities to capture term premiums created by a positively sloped yield curve, where longer-term interest rates are higher than shorter-term rates. For example, some large institutional investors are often restricted from holding maturities longer than 13 months. As a result, investors with more flexibility can earn higher returns by buying issues with 14-month or longer maturities.
• Liquidity Premiums: Benchmark bond indexes often include only the largest, most actively traded securities, and many investors similarly limit themselves to these issues and are forced to pay a price premium for maximum liquidity that is often unnecessary. The reverse is also true: as an active manager, PIMCO has the discretion to purchase securities with slightly less liquidity and thereby earn a yield premium for our willingness to invest in issues from which others are restricted.
• Volatility Premiums: PIMCO has found that it often pays to “sell volatility” in the bond market because investors usually overpay for price stability. Holding issues with embedded call or put features, such as mortgage-backed securities, or collecting premiums by selling options outright, is another source of added return largely unavailable to passively managed portfolios.
• Credit Premiums: Many investors and passively managed portfolios limit themselves unnecessarily to only top-rated credits. For example, most will not buy issues rated as “junk” (less than investment grade) by one rating agency even if another agency rates the issues as investment grade. As an active manager, PIMCO has the flexibility to purchase such “split-rated” bonds when we believe we will be more than compensated for taking additional credit risk. Our in-house credit analysis group, using a conservative and highly selective approach, is often able to identify opportunities to add substantial additional yield by assuming only modestly higher credit risk. We diversify this risk by limiting exposure to any particular company or sector.

Tactical Opportunities to Add Value
In addition to these structural inefficiencies, active bond managers can take advantage of tactical opportunities to add value that are typically unavailable to passive strategies. For example, passive strategies usually prevent the use of derivatives. But when used prudently, futures, options, swaps and forward-settled mortgage securities provide sophisticated tools for both adding return and managing risk.

One way to add value by using derivatives might be to gain exposure to a particular maturity through futures, which are often cheaper than actual cash bonds but provide the same interest rate exposure. The longer time horizon may be exploited to earn additional return by backing forward liabilities implicitly built into Treasury futures contracts with cash or higher yielding equivalents that should earn more than the financing rate embedded in the futures contract. Interest rate swaps can be even more flexible than futures because they provide a complete yield curve while Treasury futures offer only two-year, five-year, 10-year and 30-year maturities.

Other tactical strategies may be based on broad macroeconomic views. These views form the basis for identifying which maturities, sectors, or countries are most likely to outperform over the long-term. PIMCO makes particular use of this approach because we tend to have an investment horizon that is flexibly longer on average than many other market participants. By assessing opportunities within the framework of our three-to five-year secular outlook, we are often able to identify securities that have been mispriced by those with shorter-term views or less flexibility.

PIMCO’s Approach to Core Active Management
Returns on different sectors of the fixed-income market are often not closely correlated with one another or with equities, offering potentially significant opportunities to reduce portfolio volatility. While active management strategies provide opportunities to earn excess returns, reduce risk and improve diversification, not all investment managers are equally equipped to exploit these potential benefits.

The following distinct set of characteristics can distinguish an effective core active manager:

• Organizational Scope and Firm Structure:
  Many market inefficiencies are subtle and transitory. The kind of firm most likely to produce superior results is one in which the manager has a wide, multi-sector playing field and the flexibility to rotate among market segments to exploit anomalies as they arise. PIMCO’s expertise across all market sectors allows us to systematically evaluate competing investment prospects identified by our sector specialists and allocate funds accordingly. PIMCO can also shift portfolio exposures easily among sectors to seize market opportunities. By contrast, firms with fewer resources and narrower sector coverage are disadvantaged because the range of ideas from which they can choose is more confined.
• Investment Philosophy, Process and Approach:
  Another key aspect of an effective asset manager is a disciplined approach to identifying value and executing positions. PIMCO’s philosophy is to take a long-term, top-down, view of the market, embodied in our three- to five-year secular forecast. PIMCO has acquired top specialists in every sector of the bond market and these experts gather for nearly a week every year at our Secular Forum to generate our long-term forecast. Additionally, Cyclical Forums are held on a quarterly basis to identify shorter-term trends. These top-down views are then combined with the bottom-up views generated by our sector specialists and quantitative and credit research to identify the optimal strategies for implementing our long-term views in a consistent, disciplined and cost-effective way.
• Risk Management and Controls:
  Successful active management also requires the ability to continually monitor portfolios on the basis of individual security and total portfolio risk and strategy correlations. Measurement and management of overall portfolio risk is a major emphasis at PIMCO. Our portfolio managers are integrally involved in the risk management process, working directly with our Financial Engineering Group to create models that are theoretically sound, return-driven and based on market realities. Importantly, while our portfolio managers have extensive input into our analytics, our organizational structure separates the risk monitoring function from portfolio management. This separation of powers assures that those who monitor portfolio compliance with risk parameters are not beholden to those who manage the portfolio. This system of checks and balances is not always found at newer or smaller firms, but PIMCO believes it is the best way to maintain compliance with portfolio risk parameters and protect the reputation we have established over 30 years in the bond market.

A Look at Passive Management
Some investors assume that passive fixed income strategies are inherently less risky than active strategies because of the breadth of portfolio holdings and market-tracking characteristics of passive management. But passive strategies are subject to the same interest rate and/or credit risks inherent in all fixed income investing, and pose other distinct risks and opportunity costs as well.

Passive managers typically pursue one of two broad strategies: a “laddered” portfolio of bonds with staggered maturities or a portfolio that attempts to replicate a bond market index. Both strategies have limitations.

Laddered strategies typically rely heavily on relatively low-yielding U.S. Treasury bonds, particularly the most liquid “on-the-run” securities. As noted above, the most actively traded securities typically command a high price for their liquidity and provide lower yields in return.

Managers who attempt only to replicate a benchmark index are also subject to a set of distinct risks and opportunity costs. The major bond market indices are slow to incorporate new sectors and new types of securities. This can render whole portions of the fixed income universe inaccessible to passive managers, limiting diversification. Some examples of securities passive managers have been slow to adopt include mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. Moreover, because institutional demand for new instruments is sparse and the securities are less well understood, and less fully valued, passive managers may forego potential opportunities to enhance returns.

On the other hand, institutional demand for the same securities included in most indexes tends to be strong, creating competition for these “must own” issues, whether they be Treasuries, agencies, mortgages or corporates. This competition among buyers tends to make securities included in indexes more expensive. In an effort to improve returns, some passive managers “tilt” portfolios by including more agency, corporate or mortgage debt. But when applied structurally rather than tactically, the strategy relies on the weakest aspects of both active and passive approaches, producing only modestly higher yields while putting total return at risk by adding credit risk and volatility that most passive managers are less able to evaluate.

Passive management strategies are not without merits, particularly in the equity market where it can prove extremely difficult to consistently outperform the broad market through stock selection. In contrast to bond indices, which capture only a portion of the investible fixed income universe, equity indices represent the full opportunity set. A passive equity manager can thus directly replicate an index by holding all of its component securities. In PIMCO portfolios with an equity component, we attempt merely to match a broad equity index. All efforts to provide additional return over the index are made with fixed-income vehicles rather than stock selection, because we believe structural opportunities to add value are simply not available in the equity market to the extent they are in fixed-income.

Conclusion: The Active Management Advantage
Over time, the bond market offers active managers significant structural and tactical opportunities to potentially produce higher returns than passively managed portfolios. Core active managers can exploit a number of inefficiencies in the bond market to consistently provide excess returns relative to a targeted benchmark, while maintaining a risk profile similar to the benchmark.

Prudent active management requires diverse sources of added value, vigorous risk management, a long-term view and a robust process for evaluating opportunities on both a top-down and bottom-up basis. Attempts to add value should consist of small departures from the underlying index because large deviations can significantly alter risk levels and correlations to other markets and asset classes. A core active manager with expertise in all sectors of the fixed income market both domestically and abroad is more likely to identify a sufficient number of diverse opportunities to add value than those with a narrower focus and limited resources.

Passive management strategies have many inherent limitations and are subject to the same interest rate and credit risks common to all fixed-income investing. Passive managers typically have restrictions on the types of bonds in which they are able to invest, and often must purchase, at a premium, those issues that are most in demand. These restrictions limit the opportunities available to passive managers, both to add value and to diversify risk. Passive managers that attempt to overcome these restrictions by deviating from an index through additional exposure to agencies, corporate bonds or mortgage-backed securities, may be taking risks they do not understand, or their clients do not anticipate.

PIMCO’s long-term approach to core active management, global scope and expertise in all fixed income market sectors allow us to identify a broad and diverse array of opportunities to add value. PIMCO has invested heavily in proprietary, quantitative analytics and risk controls, in-house credit analysis and market expertise in order to make every effort to consistently generate excess returns without materially altering the level of portfolio risk.