Thu, 25 Sep 2014
It is still too early to know for sure, but pricing discrepancies in the Total Return ETF could be driven by a number of factors and may not necessarily reflect improprieties by PIMCO, says Morningstar's Michael Herbst.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The Wall Street Journal is reporting that the SEC is probing the pricing of securities in PIMCO's Total Return ETF. I'm here today with Michael Herbst, our director of active manager research in North America, to take a closer look at the story.
Michael, thanks for joining me.
Herbst: Happy to be here.
Glaser: Before we hit the specific news, let's start with a little bit of background about how bond ETFs, and bond open-end funds for that matter, are priced, how it might be different than equity funds, and what investors need to know about that.
Herbst: Unlike most of the stock markets, where you are dealing with exchange-traded securities, still a lot of bond purchases and sales occur over-the-counter, which essentially is two people on two sides of the table negotiating a price.
In less-liquid parts of the bond market--specifically some parts of corporate credit, some parts of the securitized market, especially more esoteric non-agency mortgage-backed securities, CLOs, CDOs--securities that trade less frequently, there is a greater chance for price discrepancies between what a firm could purchase a bond for, and what a third-party pricing service might price that bond at.
Glaser: Let's take a deeper look at that. What could drive some of this discrepancy between what it was purchased for and how it would be evaluated by these third parties?
Herbst: There are a couple of things that come into play. Ultimately, the price of a bond is what somebody is willing to sell it for and what somebody is willing to buy it for. Differences can arise in some cases. Pricing services such as Interactive Data, Thomson Reuters, and there are others, in some cases they may use recent transaction activity to arrive at a fair price. But in the case where a bond maybe hasn't traded for a couple of days, a couple of weeks, a couple of months, which is not uncommon, they may have to extrapolate in terms of what a fair transaction price may be. Or in some cases, they might estimate a price based on bonds with similar characteristics. So, for example, if they are looking at a certain mortgage-backed security, they may use similar securities to try to essentially triangulate a price.
Where some of the differences can come in are, either, again, if you have less liquid bonds, less frequently traded bonds, there is going to be longer lag times between transaction prices, so that this one area where a discrepancy can pop up.
Others differences can be … even if two bonds appear similar in many respects, it also depends on what the incentives are for the buyer and seller. So, if traditional market-makers in fixed income in recent years have been under a lot of pressure to keep inventory at a minimum, might they sell odd lots or smaller chunks of bonds at discounted prices, even though those bonds are quite similar to other bonds that they sold at higher prices? That's certainly plausible, based on the incentives.
Glaser: So, we obviously don't have any information about this specific probe. But generally speaking, do you think that some of those issues you just described could have been at play in PIMCO's ETF?
Herbst: PIMCO is not the first firm the SEC has approached about pricing discrepancies, nor will it be the last.
It is certainly plausible that some of these issues have come into play in PIMCO's case. … The PIMCO Total Return ETF is different from some other fixed-income ETFs in that PIMCO just accepts cash from investors and invests the cash. There is no intermediary. There are no authorized participants creating baskets of securities. So, in that sense, the PIMCO Total Return ETF, in our view, is just another account run in the Total Return style. That's important in case people are thinking, is there something about the ETF structure that's causing this problem.
In our view, what is more significant in this case is you have the ETF, which is a smaller, more nimble fund, starting up alongside a much larger, much more seasoned sibling. You can get very similar market exposures in both portfolios but with different mixes of securities and different prices that you bought those securities at.
If you run two bond portfolios in the same strategy, if you start one portfolio on day X and start the other portfolio on day Y, that mix of securities and mix of prices will be different.
So, in our view, those differences are likely what are driving price discrepancies if pricing discrepancies are indeed at the core of the SEC's probe.
Glaser: So, how could these discrepancies drive performance? Could this explain some of the outperformance that the ETF saw for quite some time versus the open-end counterpart?
Herbst: That's a very good question. The differences in performance will either be driven by the differences in prices that an asset manager is using for securities. For example, if higher prices were assigned to securities than the purchase prices, that in theory could lead to higher returns.
It could also be driven by realized gains when you sell those securities. If you buy securities at a discount, if you find somebody else who is willing to purchase those, you can realize gains off those securities, too. So it would be difficult to speculate on whether those were the issues driving the performance differences between the PIMCO Total Return ETF and the Total Return open-end fund.
In our view, performance differences, given some of the differences of a smaller fund versus a larger fund that we just discussed, it's plausible that those are driving the performance differences. In our view, if the two portfolios are truly being run in a similar style, those performance differences will narrow over time if the ETF continues to grow in assets. If the performance differences persist, then that raises questions about whether or not PIMCO indeed is applying the very same strategy to the open-end fund and the ETF.
Glaser: Obviously, it's early days here, but for investors in any of these PIMCO funds, is there anything to be concerned about here? Is this something that should raise any red flags?
Herbst: The notion that there might be pricing discrepancies involved in itself does not necessarily mean impropriety or necessarily raise a red flag. In our view, we would be surprised if PIMCO were applying different pricing techniques within one account versus another. But just to reiterate, even if pricing discrepancies do arise as the center of the probe, that in and of itself is not necessarily a bad thing or a wrong thing.
It does raise the issue more broadly of pricing discovery or price transparency within the fixed-income markets. Historically, that's been a challenge. It will continue to be so until bonds are traded as broadly as exchange-traded stocks.
Glaser: Michael, we certainly appreciate your early take on this news.
Herbst: My pleasure.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.