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The Benefits of Active Management

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, working with an institutional time horizon (three years or more), can
frequently 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

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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.

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• 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 institutional time horizon can be nicely exploited
to earn additional return by backing forward liabilities implicitly built into Treasury
futures contracts with cash or higher yielding bond equivalents that should earn much
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:

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• 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.

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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

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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.

Past performance is no guarantee of future results. This article contains the current opinions of PIMCO
and does not represent a recommendation of any particular security, strategy, or investment product. Such
opinions are subject to change without notice. This article is distributed for educational purposes only and
should not be considered as investment advice or an offer of any security for sale. Information contained
herein has been obtained from sources believed reliable, but not guaranteed.
Each sector of the bond market entails risk. Municipals may realize gains & may incur a tax liability from time
to time. The guarantee on Treasuries & Government Bonds is to the timely repayment of principal and
interest. Shares of the portfolio are not guaranteed. Mortgage-backed securities & Corporate Bonds may be
sensitive to interest rates. When interest rates rise the value of fixed income securities generally declines.
There is no assurance that private guarantors or insurers will meet their obligations. An investment in high-

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yield securities generally involves greater risk to principal than an investment in higher-rated bonds. Investing
in non-U.S. securities may entail risk due to non-U.S. economic and political developments and may be
enhanced when investing in emerging markets. Portfolios may use derivative instruments for hedging
purposes or as part of the investment strategy. Use of these instruments may involve certain costs and risks
such as liquidity risk, interest rate risk, market risk, credit risk, management risk and the risk that a fund could
not close out a position when it would be most advantageous to do so. Portfolios investing in derivatives
could lose more than the principal amount invested. No part of this article may be reproduced in any form, or
referred to in any other publication, without express written permission. Pacific Investment Management
Company LLC. ©2003 PIMCO.

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