Bond Giant Tiptoes into the Ring

On Tuesday, June 2, the largest bond manager in the world (outside of the Chinese government) finally unveiled its first exchange-traded fund after months of anticipation. Pacific Investment Management Company (PIMCO) runs about $750 billion in assets and grew famous through the investment prowess of its fixed-income managers and traders. In a field where success is often measured in basis points, PIMCO's flagship Total Return fund run by Bill Gross has returned 6.9% a year over the past decade, beating the BarCap US Aggregate Bond Index by more than 1 percentage point annually. On an asset-weighted basis, PIMCO's taxable-bond funds receive an incredible average star rating of 4.3. Its filing to issue ETFs at the end of last year understandably sent tongues wagging.

While there is much to like about PIMCO entering the ETF space, the now-issued ETF is less than earth-shattering. The new fund, PIMCO 1-3 Year U.S. Treasury Index , follows the Merrill Lynch 1-3 Year U.S. Treasury Index and will undoubtedly hold an almost-identical portfolio to  iShares Barclays 1-3 Year Treasury Bond (SHY). The prospectus for the new ETF (found here) even specifies that none of PIMCO's positioning talents will inform the portfolio: "Unlike many investment companies, the Fund does not attempt to outperform the index the Fund tracks." The other six ETFs announced in an additional filing today (found here) include the same key phrase in their descriptions of the funds' strategies. PIMCO plans to issue three more ETFs based on specific slices of the Treasury maturity curve, covering 3-7-year, 7-15-year, and 15+-year maturities. These will expand its offerings into a less finely sliced version of the iShares U.S. Treasury bond lineup. The other three ETFs will invest in U.S. Treasury Inflation-Protected Securities, with one broad index fund and two other indexes that cover either shorter maturity (1-10 years) and longer maturity (10+ years) sides of the market. These will be the first duration-specific TIPS ETFs on the market.

Despite the overlap with existing products, these new ETFs do bring a couple of interesting advantages. PIMCO established cost leadership right out of the gate, with its first ETF sporting an expense ratio of 9 basis points (0.09% annually). This is the lowest of all fixed-income ETFs on the market and compares favorably with the 15 basis point expense ratio of the rival iShares fund. The low expense ratio technically comes from a waiver by PIMCO that only lasts through October 2011, but its contractual management fee is still only the same 15 basis points as its rivals. Even if PIMCO chooses not to exercise discretion and tries to outperform its index, investors will still likely capture some advantage from the superior bond desk keeping down hidden trading costs for the funds. The lower liquidity and higher trading costs of these ETFs may overwhelm their cost advantage at first, but we expect PIMCO to provide great competition for iShares and SPDRs as its ETFs accumulate assets.

Still, we cannot help but hope for more from PIMCO in the future. Our own Don Phillips, when introducing Bill Gross at the Morningstar Investment Conference, mused that between his long history of successfully investing vast quantities of money, he may have made more money for more investors than anyone else in history (presumably due to Warren Buffett keeping much of the phenomenal wealth generated through Berkshire Hathaway). This is a manager whose PIMCO Total Return fund made $1.7 billion in a single day last year. PIMCO made its name with incredible success in actively managing bonds both domestic and international across its broad mutual fund and separate account business. To see it coming out with plain-vanilla U.S. bond index ETFs is like hearing that famed chef Grant Achatz is coming to your potluck lunch, then he brings over chicken salad.

Investors should thank PIMCO for driving down the cost of fixed-income bond ETFs yet again with its new entries. The efficiencies of the ETF structure and the cost-cutting it has enabled have probably saved long-term investors millions of dollars relative to higher-priced individual share classes of traditional index mutual funds. We would just like to see PIMCO extend the same cost benefits to individual investors in its flagship actively managed funds.

 

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