Your Glo

AndrewSenior VInvestme

Niels PSenior VClient A

Mihir PManaginHead ofPortfolio

obal Investme

w HoffmannVice President ent Solutions

Pedersen, PhVice President Analytics

P. Worah ng Director f Real Return o Managemen

nt Authority

n

h.D.

nt

FeaturAugust 201

Andrew Ho

Real ACapitaRisk factorsassets and private equcombining statistical toasset classeasset investbelieve riskmechanismthe underlythe typical

Real assets, afastest-growimitigate infladiversification

Investments ito physical asprivate equitywith over $20wealth funds companies. Inallocation decfour-year comprivate markeassets allocatasset valuatiounderexposedrelative to the

Up until nowcapital commacross the liqtime approaccalls. Each of risk cash and portfolio. Funfluctuations ifactor exposu

red Sol12

offmann, Nie

Assets al Calls help to ideexplain diff

uity investmethe fundamools requirees, it is posstments usin

k factor replm for privateying value dcommitmen

lso referred tong asset classtion risk, seek

n in their portf

n real assets gssets. Accordiny funds have e00 billion yet talso engage

n either case, cision is mademmitment perets portfolio mion in unfund

ons and relativd to the valueeir desired targ

, investors hadmitments in rea

uid asset classch where priva

these choicesliquid securiti

nding from eqn the portfolioures.

lution

ls Pedersen,

Replicl Conuentify the fuerences in tents that ho

mentals of reed to unlockible to replig liquid pubication is a

e equity capdrivers of print period w

o as “hard” oes across insti

k stable cash ffolios.

generally take ng to researchexceeded $67to be called. Sin direct invesa time lag oft

e and the acturiod, for exammay have the eded capital comve values acrose drivers – the geted asset al

d three basic cal asset portfoses, such as eqate equity reals has flaws. Toies would crea

quities and fixeo’s allocation

Mihir Worah

cation:undrumundamentalthe reportedold substanteal asset vak the compocate the retblicly tradedmore effectital calls. It ivate marke

while reducin

r “tangible” aitutional portfflows and ach

the form of dh firm Preqin, 0 billion in agSome of the lastments and joten exists betwual deploymenple, even an iequivalent of ommitments. Dss sectors charisk factors – llocation.

choices in maolios: 1) reservquities and boizations are ex

o fully reserve ate a significaed income maacross assets

h

: Solvinm

value drived returns oftially similarluations witonent risk faturns of privd instrumentive fundingis intended

et investmenng liquidity r

assets, remainfolios as investieve additiona

direct or indirecommitmentsgregate from

arger pension oint ventures wween when thnt of capital. Unstitution withone-quarter o

During that timnge, while invof the real ass

naging the uning in cash; 2)

onds; and 3) uxpected to funthese commitnt cash drag o

ay result in uniclasses and un

ng the

ers of real f public andr assets. By th the actors of vate real nts. We g

to capture nts during risk.

one of the tors look to al

ect exposure s to real asset 2003 to 2012and sovereign

with operatinge capital

Under a typicah a mature

of its real me, prices, vestors remainset strategies

nfunded ) reserving

using a just-in-nd capital tments in lowon the intended nstable risk

2 n g

l

n

-

w-

AUGUST 2012 | FEATURED SOLUTION 2

Finally, as many endowments learned in 2008, the timing of private equity capital flows can be very difficult to estimate, making the “just-in-time” approach a capital budgeting nightmare during extreme market conditions. Some investors have set aside a separate liquidity pool to fund illiquid capital commitments, but few have considered the potential tracking error of these reserves to their intended portfolio.

We believe there is a better solution that addresses the issue from a portfolio risk management perspective and that may allow investors to capture the factor exposures of real assets while they wait for capital calls to fund their real asset investments. The solution is to create a liquid portfolio of investments that matches the risk factor exposure of the private real asset investments. The composition of the portfolio should be based on 1) a fundamental economic analysis of the real asset investments that identifies the appropriate risk factors and 2) an econometric analysis that estimates the appropriate loadings on each of these factors.

The replication portfolio

The keys to real asset replication are to isolate the risk factors that drive investment returns of the illiquid portfolio and to find suitable liquid proxies that match those risk factors. Several fundamental tenets underpin this strategy:

Public and private investments in fundamentally identical assets should have similar returns over an investment cycle. A substantial fraction of the differences between public and reported private index returns can be explained by differences in valuation methodologies and appraisal smoothing as opposed to actual disparities in investment performance.

Portfolio analytics can be effective in isolating risk factors of asset classes when used in concert with fundamental valuation models. Real asset returns can largely be explained through exposures to market risk factors such as equity beta, real and nominal duration, credit spreads, currency, commodity and industry factors.

Liquid proxies intended to match the risk factors of illiquid investments should be designed to track the reported returns of illiquid investments over an investment cycle but will likely demonstrate tracking errors in the short term due to appraisal smoothing and differences in the underlying portfolio vs. the index proxy.

A risk factor replication portfolio seeks to capture only the beta of the investment return of the target portfolio. It will not capture the various sources of liquidity premium and alpha that may be associated with investments in private real asset markets. Investors with slightly higher volatility tolerance may be able to achieve similar expected returns of an illiquid real asset portfolio through leverage of the underlying risk factor replication proxies.

The effective implementation of a risk factor replication strategy requires a fundamental understanding of the return drivers of privately held real assets, a rigorous econometric framework and the capability to cost-effectively implement the replicating portfolio at the portfolio management level.

Analysis of real asset returns

By definition, the total return to any asset or investment has two components: income and capital appreciation. Capital appreciation in a given period can be decomposed into two components: earnings growth, and changes in multiple expansion (duration multiplied by the capitalization rate, i.e., the unlevered discount rate). The formula below illustrates these components of total investment returns:

Each real asset is exposed to changes in specific factors that affect price, volume and operating costs for those assets. For some real assets, earnings dynamics are driven mostly by price and input cost changes, while other real assets exhibit greater variability in productive volume. Volume risk tends to be more relevant in exploration and production assets and less so for fixed asset investments involving real estate, infrastructure, farmland and timber, among others. The return dynamics for the most stable cash-flow-generating assets will tend to be dominated by changes in discount factors (“capitalization rates”).

In our replication approach we include liquid investments whose returns are linked to the same factors that drive earnings potential in each of the private asset classes, as well as investments that capture the factors that affect discount rates of private asset classes.

As an illustration of this approach, Figure 1 shows estimated market risk factor exposures for U.S. farmland as well as the risk contribution from each factor. Our analysis indicates that farmland returns are predominantly driven by a couple of market risk factors, namely, commodity prices and real interest rates. Specifically, we estimate the empirical real duration of farmland is approximately 7.2 years (accounting for approximately 50% of return volatility), whereas farmland exposure to commodity prices, a combination of corn and soybean prices, is 0.4 (accounting for roughly 40% of the return volatility).

Nominal Total Return

= Cash Yield + Earnings

Growth - Duration times Δ CapRate

AUGUST 2012 | FEATURED SOLUTION 3

Figure 1: NCREIF Corn Belt subindex risk factor weightings

Risk factor

Risk factor

weighting

Estimated

volatility

contribution

Risk

attribution

Equity beta .06 40 bps 4%

Industry factor .06 -5 bps 0%

Commodity prices .39 405 bps 38%

Real duration 7.22 509 bps 48%

Liquidity .24 107 bps 10%

Implied volatility 10.5%

R2 .825 Source: NCREIF, PIMCO. Data as of 31 December 2011. Volatility is represented by standard deviation. Hypothetical example for illustrative purposes only

Consequently, the portfolio of liquid investments that, in our belief, best replicates these underlying factor exposures of farmland mostly consists of commodity futures and U.S. TIPS (Treasury Inflation-Protected Securities). Treasuries are also included to further improve the liquidity profile of the replicating portfolio. From a fundamental valuation perspective, the commodity futures exposures are a proxy for the earnings growth component of returns whereas the TIPS and Treasury exposures capture capitalization rate exposures.

Figure 2: Interpretation of risk factor replication proxies

Source: PIMCO, Bloomberg. Data as of 31 December 2011. USD Short is represented by the U.S. Dollar Index; Corn Futures is represented by the GSCI Corn Index; Soybean Futures is represented by the GSCI Soybean Index; Agribusiness is represented by the S&P Agribusiness Index; ILBs are represented by the Barclays U.S. TIPS Index; 10-Year U.S. Treasuries is represented by the Barclays U.S. 10-year Treasury Index. Hypothetical example for illustrative purposes only

Risk factor replication methodology

For a complete real asset portfolio, the appropriate liquid replication portfolio is determined in a three-step process.

First, the client defines the targeted portfolio composition of real asset classes. This is often based on a directive from a client’s investment committee or derived directly from their investment policy statement.

The second step consists of a formal econometric analysis of the targeted portfolio’s risk factors, which is validated by a fundamental analysis as described above. The asset class factor mappings are based on the private market indexes where available or based on a close liquid market proxy for asset classes without a recognized private market benchmark index. In some cases we are also able to test our results against a customized private market benchmark using transaction- or portfolio-level performance data.

Together, these two approaches help determine the component risk factors for each sector. When aggregated, these risk factors form the portfolio-level risk factor matrix that we look to replicate.

Finally, we identify the set of investable liquid proxies with similar risk factor profiles, and optimize their composition to bring the liquid replication portfolio into proper alignment with the illiquid target portfolio, while ensuring the most efficient implementation from a portfolio management perspective.

The three steps involved in our risk factor mapping and replication approach are summarized in Figure 3 for a diversified real asset portfolio that includes real estate, infrastructure, energy, metals and mining, farmland and timber.

Conc

Risk-fthorofundavaluein theThesereplic

F

The aanaly

clusion

factor-based pough understaamentals, can

e drivers of reae reported rete tools form thcation strategy

Figure 3: Rep

authors wouldytical support

portfolio analyanding of asse be effective i

al assets and inurns of publiche building bly for illiquid as

lication meth

d like to thankwas instrumen

ytics, when coet valuation ann isolating then reconciling tc and private iocks in a risk-sset classes.

hodology ov

k Bob Greer, Bntal in both th

ombined with nd operating e fundamentathe differencenvestments. -factor-based

verview

Bruce Brittain ahe developme

a

al es

We effeexpcondevcapconliab

and Ashish Tiwnt and proof o

believe a riskective means oposures of an insider evaluativeloping a dedpital commitmensidered as a rbilities.

wari for their cof the investm

AUGUST 2

k factor replicaof capturing tilliquid real assng and quant

dicated fundinents. Risk factrisk managem

comments andment thesis.

2012 | FEATURE

ation portfoliohe intended mset portfolio. tifying their liqng mechanismtor replicationent solution fo

d guidance, a

ED SOLUTION 4

o may be an market factor Investors shou

quidity risk and for their illiqu should be or these

nd Fei He who

4

uld d uid

ose

Newport Beach Headquarters840 Newport Center Drive Newport Beach, CA 92660 +1 949.720.6000

Amsterdam

Hong Kong

London

Milan

Munich

New York

Singapore

Sydney

Tokyo

Toronto

Zurich

pimco.com

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. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors.

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. The NCREIF Corn Belt subindex is included in the NCREIF Farmland Index, which is a quarterly time series composite return measure of investment performance of a large pool of individual agricultural properties acquired in the private market for investment purposes only. All properties in the Farmland Index have been acquired, at least in part, on behalf of tax-exempt institutional investors - the great majority being pension funds. As such, all properties are held in a fiduciary environment. The S&P Agribusiness North America Index consists of 24 of the largest publicly-traded agribusiness companies trading on the U.S. and Canadian exchanges that meet specific investability requirements. The index is a breakout of the S&P Global Agribusiness Index, an equity based index designed to provide liquid exposure to 24 of the largest publicly-traded agribusiness companies comprised of a mix of Producers, Distributors & Processors and Equipment & Materials Suppliers companies. It is not possible to invest directly in an unmanaged index.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is 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.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Munich Branch (Company No. 157591), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Services Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam, Italy and Munich Branches are additionally regulated by the AFM, CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, and BaFin in accordance with Section 53b of the German Banking Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Services Authority's Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO Asia Pte Ltd (501 Orchard Road #08-03, Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. PIMCO Asia Pte Ltd services and products are available only to accredited investors, expert investors and institutional investors as defined in the Securities and Futures Act. | PIMCO Asia Limited (24th Floor, Units 2402, 2403 & 2405 Nine Queen’s Road Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL 246862 and ABN 54084280508, offers services to wholesale clients as defined in the Corporations Act 2001. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and Investment Trusts Association. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (120 Adelaide Street West, Suite 1901, Toronto, Ontario, Canada M5H 1T1) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. © 2012, PIMCO.