Mon, 8 Jul 2013
The performance differences have narrowed between the two funds recently, and Morningstar's Tim Strauts and Eric Jacobson say PIMCO investors should choose the least expensive option.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Should you buy PIMCO Total Return in exchange-traded fund format or in traditional mutual fund form? Joining me to discuss that question is Tim Strauts and Eric Jacobson. They are both senior fund analysts with Morningstar. Eric is on the phone with us, and Tim Strauts is here in the studio.
Tim and Eric, thank you both for being here.
Tim Strauts: Thanks for having me.
Benz: I think we can agree that the two funds probably have more in common than they have differences. But, Eric, let's discuss one of the key differences, which is that the traditional mutual fund can own derivatives, the ETF version cannot. Let's talk about how big a role derivatives have played in the traditional mutual fund over the years.
Eric Jacobson: Sure. Historically, the traditional mutual fund has held a lot of derivatives, but more in terms of making a statement on whether or not one of the markets is a little richer or cheaper than the other. So, for example, if the derivative looks a little cheaper than the cash bond market, they might go with that or vice versa.
Benz: So, Eric, would you say that the derivatives have picked up in importance over the years as PIMCO Total return has become a giant fund?
Jacobson: I think to some degree it's helped them manage liquidity because the fund is so large. But they've actually been peeling back over the last year or so, trying to take some of the complexity and some of the market risk out of the portfolio by using fewer derivatives.
Benz: Tim, a question for you, another key difference is that as an actively managed exchange-traded fund, PIMCO Total Return has to publish its holdings daily, and I think that anytime you see that, you wonder, well is that going to subject it to front-running by people trying to get ahead of the fund building its positions. Is that a concern? Has it been a concern for the ETF so far?
Strauts: Well, I don't really think it's been a concern, and manager Bill Gross has said as much in some of his comments that he feels that the bond market in general--when PIMCO goes out to the bond market to purchase securities, the market gets a feel what PIMCO is doing. So, I don't feel that the daily disclosure has any way impacted them. I mean, frankly, PIMCO has had separate accounts for many years to run the Total Return strategy that also investors could look through those.
The impact of front-running in the bond market is very difficult to do. I mean front-running is more possible in the equity market. In the bond market, you're not going to get ahead of PIMCO. If PIMCO is buying a bond, oftentimes they're buying all that's available in that particular issuance. You can't get in front of what PIMCO is doing. And if they started allocating more money to Treasuries, you can't front-run Treasuries; the Treasury market is so much larger than PIMCO. So, front-running is really not a concern in the bond market right now.
Benz: Eric, do you agree? Do you think that that's not a concern that daily disclosure that the ETF has to make?
Jacobson: I agree with Tim on that. I think that to the degree that it even might have been, I think PIMCO made a strategic decision that it wasn't enough to dissuade them from doing an ETF. So, pretty much the same answer. But again, I think they made a strategic decision not to worry about it even.
Benz: When you look at the two portfolios' weightings, Tim, and compare them side-by-side, do you see any significant differences, or are they pretty much mirror images of one another, the ETF versus the traditional mutual fund?
Strauts: I think there were more differences when the ETF first launched, but when you look at the portfolios today, you can kind of compare the May 31 portfolio holdings, and the allocations generally look very similar, with categories differences by 1% or 2% here or there.
The one area that is a little different is emerging-markets debt. The mutual fund looks like it owns about 7% to 8% emerging-markets debt, and the ETF only about 2%. As we know, emerging-markets debt has done poorly in the last few months. So, that could be one reason for some return differences in the two funds.
Benz: I want to drill into the return differences a little bit because initially at least, they were quite substantial. People said, "Oh, my goodness, the ETF version is performing so much better than the mutual fund." Let's talk about the returns of one product versus another since inception. And also, Tim, you noted that they have narrowed a little bit in recent months, so let's talk about what's going on there.
Strauts: Yeah. So the institutional share class of the mutual fund since the ETF's inception of March 1, 2012, returned 6.0%, and the ETF has returned 11.3%. So, it's an outperformance of a little over 5% in just a little over a year. And the main reason we've seen the difference is that when the ETF was launched, it was launched with just $100 million in the portfolio. So, with the $100 million, PIMCO was able to implement all its best ideas in that portfolio.
And as you can see when you have an organization like PIMCO with as many analysts and as many people doing fundamental research, their best ideas--if you can concentrate them in a small fund--can have a really big impact. Now, since then, the ETF has now grown to over $4.5 billion. So, it's no longer quite of a best-ideas portfolio. So, as you'd expect, we've seen the performance differences narrow between the ETF and the fund.
Benz: Eric, any comment on recent performance or on the performance differential between the two products? Do you generally agree that it sort of chalks up to the ETF being able to be sort of a best-ideas fund in its early days?
Jacobson: Yeah. The only thing I would add there is just that I think it's made the ETF a lot more nimble in terms of moving in and out of those best ideas. So, even with the best ideas being there, the mutual fund having almost $300 billion [in assets], even if an idea changes one way or the other, getting in or out of something is going to require a lot of trading and a lot of time, whereas I think you can move the ETF a lot more quickly.
Benz: A related question for you, Eric, is as the ETF grows larger, do you think that it will sort of find itself in the worst of both worlds? So it cannot use the derivatives that you noted that the traditional mutual fund has to sometimes put cash to work and it also can't build and maintain some of these large positions as perhaps it could in the past. What's your take on whether, in fact, the ETF may fall behind the traditional mutual fund at some point in the future?
Jacobson: I actually think that's pretty unlikely. I think that there are couple of things here. One is that, I think the advantage to the Total Return mutual fund is a little bit overstated in small part because the ETF can use forward contracts. And a lot of the derivatives that the mutual fund uses are related to the mortgage market and what we call TBAs, to be announced forward contracts. So, the ETF can use those and that makes some difference in terms of what kind of mortgage exposure the fund gets.
On the other hand it's not such a problem, certainly at this size, to not have derivatives. As I said before, I think that the big fund relies on them somewhat less than people realize in terms of generating its excess return. It's usually more of a basis-point kind of question. So, I don't think it's going to be a big deal for the ETF, certainly not at this size. If it gets up to $100 billion, $200 billion anything like the mutual fund, we'd have to sort of revisit it. But at least this stage, I don't think it's that big a deal.
Strauts: And I guess I would just add that the ETF could eventually invest in derivatives if they get an amended prospectus. And the reason the ETF doesn't have derivatives available right now is that the SEC was concerned about derivatives in ETF portfolios. And in the years ahead, I would expect that as the SEC gets more comfortable with what providers are doing that that restriction will get lifted.
Benz: So the big question for you two really is for people looking at these two products or who maybe own one and are looking at the other, how do they decide which is the best product type for them? Obviously, they get some features with ETFs, such as the ability to trade intraday, that are not there with the traditional mutual fund, but for people attempting to navigate this decision, what should they be looking at, and what should it come down to?
Strauts: I would just say, obviously it depends on where you are investing. In some platforms, you may be limited on what share classes you can have access to in the mutual fund. In general, I would look for the lowest-cost share class. So if you can get access to the institutional shares, with an expense ratio of 46 basis points, that may be the preferred option. The ETF's expense ratio is 0.55%. So it's a little bit higher. But if you only have access to say, the [mutual fund's] A shares, then I would look at maybe the ETF as maybe the better solution at a lower cost point.
Benz: Eric, you've been our PIMCO Total Return guy for a long time. What's your take on that question: ETF versus traditional mutual fund?
Jacobson: I couldn't agree more with what Tim had to say. The PIMCO Total Return mutual fund has a lot of share classes, many of which we think are overpriced when they are designed for retail investors. The institutional share class fortunately is available to a lot of individuals through 401(k) platforms and other investment advisory platforms. So, you definitely want to take a look at that and see if you have access to it. If you don't, though, the ETF is probably a great way to go.
Benz: Well, thank you both for being here to shed insight on this very important question for a lot of investors.
Strauts: I'm glad to be here.
Jacobson: Thanks, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.