Thu, 10 Oct 2013
This Bronze-rated fund offers a compilation of PIMCO's best investment ideas, but its recent middling performance doesn't justify the high cost, says Morningstar's Eric Jacobson.
Christine Benz: PIMCO Unconstrained Bond Fund, this is a fund that is much less constrained to a specific benchmark. Let's talk about the general thesis behind that fund because even though it has been getting very big inflows, I've wondered if investors really know what they are getting with this specific fund. So, what does it set out to do?
Eric Jacobson: Well, the overarching idea is to take the same themes that are set by PIMCO's Investment Committee at a very high level--that includes Bill Gross, Mohamed El-Erian, and other very senior members of the team. They set their overall views on where they think things are going [and] what kind of risks they think managers should or shouldn't be taking in portfolios.
Then, there is an Unconstrained Strategy management team that takes those inputs from the Investment Committee, develops their own sort of finer opinion of what kind of risk exposures the Unconstrained Strategy should or shouldn't take. And then they essentially tap the entirety of the firm for its best ideas. This is the same sort of framework that Total Return operates in. When the fund has its cyclical and secular forms, all the managers in the fund need to contribute a handful of ideas that they think are that going to offer the best risk/return within their given areas of expertise, and the responsibility of the Unconstrained management team is to decide how much to weight those bets within the framework of not being benchmark-dependent.
So, they don't have to own everything if they don't want to. And if things look particularly enticing within the risk framework that they are running, they can build up more of that than you might normally find in the Total Return Fund.
Benz: Interestingly, despite the big differences with the Total Return Fund, we've actually seen performance be not that far away from one product to the other year to date, and Unconstrained Bond Fund is not having a great year relative to its peers. What's been behind its recent performance?
Jacobson: It is interesting because one might think that some of same exact drivers have hurt this fund, and they haven't been identical. As you know the fund is off about 1.5% for the year to date, but they weren't really caught so much with duration being a problem during the recent sell-off; the fund was at only one and a half years at the end of May, which is relatively low. And not only that, they had a whole variety of hedges on the portfolio to protect against different kinds of market shocks, they even had a complex option on the portfolio that would have kicked in had equity sold off sufficiently and the rates had risen sufficiently, but neither one of them quite got to the point where the option kicked in.
Overall, they describe it as sort of a breakdown of correlations, really leaving the fund where it has wound up because of the fact that the hedges didn't kick in, they didn't work quite as one might have expected given the fact that correlations were very high among things that don't normally correlate that well during this period.
If you are looking to see what exactly caused the pain, one of the things that hurt them the most was that Brazilian interest rates reacted much more severely than they would have expected, given the overall things that were going on in the market, and the fund had around 18% emerging markets at the end of May, so that gives you an idea of where some of those risk exposures were, despite the fact that they had hedges going on.
I don't want to overstate the trouble; a point and a half of loss for the year to date in the grand scheme of things probably isn't all that bad. But it is an issue, I think, for investors who come to expect some sort of absolute-return perfection in funds like this. That's not a reasonable thing to expect, but it is reasonable to take a look at it and say, "I really wasn't expecting a loss here."
Benz: So, you've got this particular fund at Bronze, Eric, its rating is Bronze. Let's talk about the pros and cons of this fund when you think about its forward-looking prospects?
Jacobson: Well, the biggest thing from a forward-looking perspective is the fact that the costs are not only relatively high in the category, but they are kind of high here, too. The institutional share class, which we focus on because it is the largest and it does have availability across platforms even for smaller investors--depending on how they access PIMCO, if they use financial advisors and so forth--but the cost is about 90 basis points or 0.9% just for the institutional share class, and it's higher for the other share classes. That's a big hurdle to get over, especially for a fund that doesn't use much duration, doesn't get what we call the term premium in the bond market as a result of that, and has this sort of absolute-return mandate. So that's going to be a headwind no matter what going forward.
Like you said, we do give it a Bronze rating and the main reason for that is we do think it still offers the best thinking of PIMCO really across the board in terms of sectors and macro thinking. And it does provide an outlook for investors who are really concerned about bond risk, in general, and not wanting to remain tight to a duration-driven benchmark. But the bottom line still far in terms of how it has performed as though it's been kind of up the middle in terms of nontraditional bond funds and has been a little bit less volatile and that rounds out the picture and helps us get to the point where we think this is an acceptable decent choice for people within this category, but we are still keeping an eye on it.
Benz: You mentioned the expense ratio that 90 basis point expense ratio for institutional share classes and higher expense ratios for the other lettered share classes. Will you be looking for those expenses to trend down given that the assets in the fund have stepped up so dramatically?
Jacobson: Well, I would argue that they absolutely should, and I'll pound that drum as often as I can, as much as I can. But to the degree that anyone is going to listen outside of PIMCO is a big question, because they don't have a really strong history of lowering their expense ratios with size, although they have once in a while shaved a few basis points here and there.
It will be interesting to see how this goes, because I don't know if they can necessarily continue at this rate with this kind of performance. I'm not saying that it's bad, but as I described, it is relatively middling and whether or not investors are going to continue to favor the fund with these kind of flows at these kind of performance levels and at that price.