Is PIMCO Total Return ETF the Crossing of a Rubicon?

PIMCO filed a preliminary prospectus last week that was received like chum in the exchange-traded fund waters--the PIMCO Total Return ETF.

Champions of the ETF view PIMCO's Total Return entree as a watershed moment. It's one thing to have a big lineup of index funds and a handful of mostly unremarkable actively managed portfolios available as ETFs. It's another altogether when one of the most successful, highest-profile active managers in the asset-management business plans to run an ETF with the same strategy used in his flagship fund. (Despite its name, the ETF will not be a Vanguard-style share-class offshoot of  PIMCO Total Return , and its portfolio may at times look different, as well.) The fact is that while passive ETFs have been legitimized and broadly accepted by investors and asset managers alike (notably Vanguard and BlackRock), active ETFs have existed on the periphery, without any clear indication that they were truly viable for the most sought-after active managers. For some, that recognition has been a kind of Holy Grail.

Boosterism aside, the strongest argument for lauding this development is that it could act to disrupt some obstacles that otherwise separate small investors from institutional-quality managers. Although PIMCO's institutional shares are relatively inexpensive, for example, they are difficult to access, unless you have millions of dollars to invest, you're investing through a financial intermediary who charges you directly, or you invest via a large retirement plan. Meanwhile, the firm's retail share classes (A, B, C, and D shares, in particular) are all designed for distribution to investors through intermediaries such as brokers and fund supermarket platforms. And though PIMCO is actually cutting the costs on some retail share classes on May 1, they will still include layers of fees to pay for account administration and to compensate those intermediary players.

Power to the People?
That scheme isn't at all unique to PIMCO, but ETF fans are hoping that its plans will allow investors to stage an end run around the whole thing. In theory, PIMCO Total Return ETF should be priced relatively close to the 0.46% institutional class of its open-end cousin (the preliminary prospectus does not include a price tag) yet be available to anyone with a basic brokerage account who can buy and sell a share just as easily as with any stock. Administrative costs will be borne by the brokerage firm and stock exchanges that charge commissions to investors when they trade. ETF buyers won't have to pay distribution costs beyond their trading commissions, unless they're otherwise working with a financial planner and pay him or her directly.

Still, PIMCO hasn't announced the fund's cost structure yet, and it's not a foregone conclusion that this model will sweep the industry and slash the presence of distribution costs. Despite the historical success of no-load, direct-to-consumer firms such as Fidelity and T. Rowe Price, even they eventually rolled out share classes with extra fees built in, essentially to make them "salable" via brokers and financial planners who wouldn't otherwise have any financial incentive to offer them to clients. Almost every fund company that swore allegiance to a single distribution model in the 1990s has since morphed into a seller of funds with load and no-load structures. Vanguard is one of the only firms, aided by its massive size and unusual mutual-ownership structure, that has managed to flourish without distribution fees built into its share pricing. Nearly everyone else is unwilling--or financially unable--to hoe the difficult row of advertising directly to individual investors or cajoling financial advisors to use their wares, without layering on fees to make up the costs.

First, Do No Harm--To Us!
For current PIMCO clients, whether interested or not in ETFs, the questions may be more philosophical. The firm oversees more than $1.2 trillion investor dollars, spread across mutual funds, retirement plans, pension funds, and other structures. As stewards of that money, PIMCO has a responsibility, first and foremost, to do what's in the best interest of its current clients.

It's not clear that this move to establish a PIMCO Total Return ETF meets that test, and it's a topic of fierce debate among analysts at Morningstar. PIMCO does not have a history of closing funds that get large; it looks for better ways to manage them. PIMCO Total Return has grown massive; the $236 billion fund is only one slice of the nearly $400 billion that Bill Gross is responsible for across a variety of accounts. To top it off, other managers at PIMCO run additional money in a very similar style. The firm's demonstrated ability to do so successfully in the past doesn't mean there aren't risks to the fund's future success. It could be as simple as performance moderating slightly as each incremental dollar makes it more difficult for PIMCO to fully--and prudently--capitalize on opportunities in markets that look smaller and less liquid in relation to a fund that has grown larger and in need of bigger positions. Or the sheer sum of money in Gross' care could pose more serious challenges if a change in his outlook or a rapid pickup in outflows requires him to move swiftly at a time when market liquidity happens to wane.

Meanwhile, one of the bedrock concerns about actively managed ETFs has long been that the daily disclosure necessary to facilitate the underlying trade mechanisms of the ETF structure could disadvantage a portfolio by allowing others to more easily trade against its positions and siphon off returns. While sometimes thought of as an exaggerated worry for less-impressive managers, it is by definition a real concern for a manager as closely followed and successful as PIMCO's Bill Gross.

Still, some believe that concern to be overblown and figure PIMCO's tutelage over institutional separately managed accounts must mean its Total Return fund positioning is already effectively being telegraphed to the market on a daily basis. It also remains to be seen just how much information PIMCO is going to release every day; the language in its ETF preliminary prospectus seems to leave a lot of wiggle room.

But while there may be some truth to the suggestion that information is already leaking out, it may be more a kernel than a cob. For one thing, PIMCO has tremendous control over whom it chooses to call its separate account clients. Its minimum account size is $75 million, making it unlikely that most such clients would jeopardize their own returns, or PIMCO's willingness to manage their money, by publicizing the trades in their portfolios.

And even if information is already seeping into the market, it doesn't mean PIMCO fund investors have nothing more to lose. A modest level of additional information leakage via ETF disclosures still has the potential to chip away at the returns of a giant portfolio the size of PIMCO Total Return. Bill Gross has never given investors any reason to think he would like to see that happen, but it's not unthinkable that PIMCO would accept the risk if it means staking claim in an ETF market some believe--or worry--could eventually erode the dominance of mutual funds.

Are We on the Camel's Back?
And while Gross and PIMCO have done an excellent job shielding most of their funds from severe damage during crises, there is almost certainly a lot more fickle money in the PIMCO Total Return fund today than there ever has been. The past couple of years saw bigger inflows here and in the broader bond-fund universe than any period in history. These newcomers undoubtedly have high expectations. Not only have the past five years and 10 years been really good to bond funds generally, but Gross has been one of the very best managers over that time. Bond markets are facing headwinds they've not seen in decades, and Gross, like any great manager, is susceptible to periods of underperformance. With so many new investors having joined the fold, there's good reason to think only a modest number truly understand Gross' management style or how the fund actually works. If a rising-rate shock were to grip the market, it's anyone's guess how many of those investor dollars might flee, even if PIMCO Total Return's performance were good relative to other bond funds. PIMCO is as well equipped to handle such eventualities as any manager, but it's almost impossible to gauge the potential procyclical follow-on effects for the industry or market if the largest fund in history were to begin bleeding assets at a rapid clip.

The addition of an ETF to this mix isn't itself necessarily going to make a meaningful difference. Those more sanguine about the idea argue that PIMCO is likely agnostic about the channels through which its assets come and ask why it matters if the next billion in inflows come from an ETF or the traditional mutual fund. Rolling out an ETF at this point may simply be an effort on PIMCO's part to protect the flanks. That means providing an option for investors who want to be clients of the firm but have their own reasons for favoring ETFs and might otherwise take their dollars elsewhere. There's a compelling logic to the idea that, if the market begins to favor one structure over another, it makes sense for a money manager to offer that format unless there's something inherently wrong with it.

Looking Out for Number One
Skeptics see more self-interest at work. PIMCO has made clear aspirations for growth over the past couple of years, rolling out numerous funds as adjuncts to its fixed-income stable, starting up an equity management group from scratch, and even taking over the distribution and wholesaling functions for its funds from another Allianz subsidiary that had been responsible for those efforts.

Those who see little altruism in PIMCO's motives argue against viewing its ETF rollout as any kind of principled crusade to fight against the prevalent mutual-distribution model. If that was PIMCO's real goal, the firm could have simply made adjustments to its share-class structure and fee combinations and perhaps used its heft to put direct pressure on fund supermarket platforms to lower their own share of the take.

In fact, what's so troubling if one accepts this line of reasoning is the combined picture--new "products," unrealistic investor expectations, high fees, marketing muscle, and rapid growth. In managing those without hurting investors, PIMCO has thus far been a nearly lone exception to an otherwise nearly immutable rule. It's almost impossible to grow that much, and that fast, in the business of money management, however, without placing your own interests in front of your clients'.

Karen Dolan, director of fund analysis, contributed to this column.