Q: What is the goal of the fund and what makes it different from its peers?

One of our objectives at PIMCO is to provide inflation protection solutions.  These include investing in Treasury Inflation-Protected Securities, or TIPS, and Real Estate Investment Trusts, or REITs. We are unique in the market, because, in this fund, we invest in REITs and inflation-protected bonds. We maintain an actively managed exposure to REITs and we back that exposure with bonds to gain incremental inflation protection. We believe that this is a capital-efficient approach for investors who seek return and inflation protection.

Q: Do REITs offer a non-correlated investment return?

We believe that REITs represent a good way to get exposure to physical real estate in a liquid and transparent way. We track a REIT index that focuses exclusively on real estate companies, excluding financial companies. That means that we own only the REITs that have physical assets in buildings and deliver the returns of that physical real estate.

Since REITs actually represent a collection of physical buildings, such as shopping centers, data centers, multi-family apartments, storage centers, etc., in the long run their performance tracks the physical assets closely. There is no reason for a correlation between these assets and the broad equities, except for the short-run correlation caused by the daily liquidity.

In the short-term, day-to-day trading REITs display a high degree of correlation with the broad equity markets. With a longer horizon, however, they have very low correlation with the broad equity market or the S&P 500 Index. REITs have daily liquidity and investors trade them as equities, so they look like equities in the short run.

Q: What core beliefs drive your investment philosophy?

The investment philosophy of all PIMCO funds is similar. We believe in active management and we actively manage both the REIT portion and the TIPS portion of the portfolio. Our investment philosophy is to combine macro insights with bottom-up thinking and to build diversified portfolios. We make many different investments that are sized according to our conviction. We don’t believe in making just one or two large investments. We seek a well-diversified portfolio both in terms of the REITs and the management of the TIPS.

Another aspect is that we are mindful of the starting point or the index. That’s important because we could always get passive exposure to that beta at a relatively low cost.  It is also important for the investor to be able to measure the skill of the manager; to know how much alpha the fund delivers versus the risk or the volatility and relative to the benchmark. We seek to maximize the Information Ratio, or IR, which is important for investors who believe in active management.

Through our valuation framework, we aim to identify the REITs that are going to outperform. They should have attractive price/NAV ratios and unlevered Internal Rate of Return, or IRR. Our approach to value determines the active investments we take, but we try to maximize the Information Ratio, which inherently maximizes total return. In this fund, we always try to address the maximum total return, while being cognizant of the risk and the type of investment. We make sure to not deviate too far from the REIT index, because our investors expect a high correlation to the underlying investment.

Q: Would you describe your investment process?

The key aspect of the investment process is managing two different sources of return for the fund. Investing in both REITs and TIPS means that the returns are driven by both beta and alpha in REITs and TIPS. Therefore, we actually have four different buckets - REITs beta, REITs alpha, TIPS beta and TIPS alpha.

For REITs, a team of credit analysts focuses on individual securities and establishes valuation views. Based on these views, we form an opinion whether the company is overvalued or undervalued. It is a function of the unlevered IRR of the REITs based on the current trading levels and the expected return for each name.

In the portfolio construction process, we overweight the names with better forward-looking returns and underweight the others to create a fairly diversified basket. The size of each position is proportional to the amount of mispricing that we see in each market. We are always aware of the market cap and the natural weighting based on the market cap. Then we deviate from that weighting based on the relative richness or cheapness of the REIT.

On the TIPS side, we follow our traditional active fixed income process, which includes economic forums and the investment committee formulating views helping to inform how investment strategies – both top down and bottom up – are developed by our team of inflation-linked bond portfolio managers.

Q: What is the allocation between REITs and TIPS? Do you have a ranking system for the REITs?

When investors invest $100 in the fund, they receive $100 of exposure to REITs and $100 of exposure to TIPS. More specifically, we invest in the one-to-five year TIPS market, so interest rate risk is only modest. We believe that is a capital-efficient way to get exposure to these two different sources of beta, because the investor can own TIPS and REITs with one allocation.

We monitor the portfolio on a daily basis to adjust the weightings and to respond to changes in valuation and fundamentals. That is a constant, real-time process. That’s why active management is important. We can look at what NAV the REIT is trading and we can see the NAV of each of its assets. That analysis enables important decisions about the valuation of a particular REIT and, therefore, how much of it makes sense to hold in the fund.

Q: What is the cost of leverage in that $100 investment?

The cost of leverage for TIPS, which are U.S. government bonds, is quite low. We can find TIPS close to the trading level of short-term bonds, which means that they are effectively close to the T-Bills. The benefit of extra exposure to TIPS depends on whether the one-to-five year TIPS outperform or underperform the T-Bills. If the T-Bills are on 2% and the one-to-five year TIPS are on 3%, we would expect a return of 1% from owning those TIPS. The big drivers behind the one-to-five year TIPS are inflation and especially oil prices.

The main proposition of the fund is to provide exposure to REITs and some extra inflation protection in a capital-efficient way. A standalone allocation to TIPS would result in low volatility and relatively low return, so we pair TIPS with REITs, which have equity-like returns. Overall, the fund is for investors with a focus on return and inflation protection at the same time. If investors don’t like TIPS and don’t want to own them, then the fund may not be a good fit for them.

The allocation in TIPS could provide positive returns, because there should be an incremental return from the modest level of interest rate exposure. In periods with disinflationary pressure, like 2014 for example, it would be natural for this fund to underperform. But in other periods the fund should do well and outperform.

Q: How do you organize your research process?

The biggest difference between REITs and other investments is the amount of available information. REIT companies publish a lot of information, so we can have access to detailed valuation metrics. Overall, we follow the same process as elsewhere within PIMCO. We combine macro insights with bottom-up, asset-specific views and bring them together in a diversified portfolio.

Importantly, the REIT alpha is uncorrelated to the active management of the TIPS. That means that we have two different markets to express our views. The views that we take can behave and evolve in different ways. Importantly, the uncorrelated active positions can improve our Information Ratio. We may have 10 or 20 trades in the TIPS space, as well as overweights and underweights versus the REIT index, but those two views aren’t correlated. The result is a higher IR and more outperformance than if we took positions in REITs or TIPS on a standalone basis.

Q: What is your portfolio construction process?

As a general rule, we size the positions relative to our conviction. The best way to quantify conviction is through the Sharpe Ratio of each investment. For instance, if we think that an asset has expected return of 5 and risk of 10, its Sharpe Ratio is 0.5. That means that we should size that position twice as big as another investment with expected return of 1, volatility of 4 and a Sharpe Ratio of 0.25. We believe that sizing the positions based on the expected Sharpe Ratio is the optimal strategy for portfolio construction. That applies for both TIPS and the REIT side.

Our main task is to come up with a view of the expected return, understand the risk of that view and use the analysis to allocate risks appropriately. We allocate a number of views and then track them to measure how we have done. We constantly try to learn from what we do well, what we don’t, and to adjust our behavior accordingly.

Q: How do you manage you sector-based exposures?

We don’t explicitly constrain our exposure on a sector basis. Instead, we consider the amount of risk that we have allocated to a trade. In that way we can put on equal footing REITs, a higher-volatility asset, and TIPS, a lower volatility asset.

Nevertheless, we definitely keep in mind how much of our risk comes from sector overweights and underweights and how much comes from individual name overweights and underweights. We try to understand where we have more relative scale. In terms of exposure, our philosophy is to focus on how we assess richness and cheapness.

Everything else being equal, we would probably expect to have a small overweight in sectors like apartments and data centers. We don’t necessarily have to, but historically our process has produced small sector tilts that maximize total return. We tend to manage the risk of those overweights and we avoid taking large bets, but we do think that certain sectors have naturally slightly better total returns than other sectors.

Q: How do you define and manage risk?

Our basis for making investment decisions is the Sharpe Ratio, which literally is the return divided by the risk. So, risk management starts at the very beginning of our process. We can’t consider any investment without considering the risk associated with it. By itself, expected return is a somewhat meaningless number.

We believe that we need to consider risk from the beginning to the end of the process. We look at aggregate risk across the entire portfolio, taking into account the correlations between our different investments and making sure that we are comfortable with the risk profile. That risk profile should be consistent with the expectations of investors.

We have a proprietary in-house risk system, which we use to monitor risk in the portfolio. There is an independent risk management process built in the DNA of the fund and the firm. An important aspect is our strategy of making many different risk controlled investments, as opposed to picking only a few names. We make a variety of investments to get the benefit of diversification and we always track our risk to make sure that we will be rewarded for it.