Once Again on Top

On Sept. 3, 2013, a deposed monarch was crowned again. Few took notice, as his domain is the still tiny realm of actively managed ETFs. On that day,  PIMCO Enhanced Short Maturity ETF (MINT) unseated its younger sibling,  PIMCO Total Return ETF (BOND), to retake its throne as world's largest actively managed ETF.

Though a minor drama, it's part of a bigger movement by investors to reduce their bond-duration risk. Ben Bernanke kicked off the process when he mentioned during a question-and-answer session that the Fed might "taper" its bond purchases later in the year (which didn't happen). The news that Uncle Ben's helicopter drops of money might slow down earlier than expected sent investors stampeding out of bonds. Faced with capital losses on rising rates and zero yields in cash, some have compromised by piling into ultra-short-duration bond funds, until recently a sleepy backwater of the fund world.

According to Morningstar's Asset Flows, over the three months ended Sept. 30, 2013, MINT received just over $423 million in net inflows, while BOND received more than $483 million in net outflows. During this period, mutual funds in Morningstar's ultra-short bond category saw $6.9 billion in net inflows, while those in the intermediate-term bond category $47 billion in outflows.

ETF sponsors have launched imitators, all within the past couple of years. The newest entrant is iShares Short Maturity Bond (NEAR), which follows SPDR SSgA Ultra Short Term Bond ETF (ULST), FlexShares Ready Access Variable Income Fund (RAVI), and Guggenheim Enhanced Short Duration Bond ETF (GSY).

It would be a mistake to dismiss these funds as just another fad. I think we're witnessing the birth of a new kind of shadow bank. Economically, a bank is a company that uses deposit funding to lend long term. Money market funds are shadow banks. So were structured investment vehicles, or SIVs (until they went extinct during the financial crisis). Ultra-short-maturity bond ETFs, by offering daily liquidity, close-to-stable NAVs, and higher-than-cash yields, are the outcome of the latest iteration of that age-old game between regulators and bankers: The regulator sets up new rules to curb unregulated deposit lending and financiers devise workarounds to keep on lending and make a handsome profit in the process.

New Shadow Bank, Meet Old Shadow Bank
On Sept. 15, 2008, Lehman Brothers filed for bankruptcy. The next day, the money market Reserve Primary Fund was forced to mark down its Lehman paper. Unable or unwilling to plug the hole out of their own pockets, the managers set the fund's share price to $0.97, "breaking the buck."

The market's reaction was swift and terrifying. Institutions began pulling their money out of money market funds. A run on the shadow-banking system was underway. Fortunately, the U.S. Treasury killed the panic by stepping in to insure all money market deposits.

The realization that MMFs are really a kind of bank has led regulators to restrict the funds from owning too many illiquid or high-yielding cash instruments. Laboring under so many restrictions in a zero cash-rate environment, MMFs struggle to offer yield at all. Combine this with the low interest rates set to last for years and regulators on the warpath to reform the MMF industry, and you have a doomed business model. Enter PIMCO Enhanced Short Maturity Strategy, the first of the actively managed ultra-short maturity ETFs.

The fund is an unabashed piece of regulatory arbitrage. It's designed to skirt money market fund rules, allowing it to own the securities just beyond the bright line that regulators have drawn. You have to admire PIMCO's farsightedness. The firm identified an opportunity in that in-between area where bond maturities are too long for most MMFs and are too short for most short-duration bond funds. The relative scarcity of capital means such bonds offer relatively attractive yields, especially in relation to the risks they run.

MINT has a wide-ranging mandate to make the most it can of the crevices, nooks, and crannies of the short-term paper market. The fund can venture down the quality scale to slightly speculative fare and even abroad. It will typically keep its duration under one year and its weighted average maturity under three years.

One, however, must never forget that MINT is not a MMF. It does not guarantee a fixed price level. It's also not too big to fail, so don't expect the government to ride to the rescue should it need rescuing.

However, as far as ultra-short bond funds go, you could do much, much worse than MINT. History shows investors should be extra cautious with their cash investments in a low-rate environment. Many big investors who target expected returns, such as pensions (and to some extent MMFs), may be stretching for more risk with cashlike instruments, driving up prices. In the past, these bets haven't been well compensated, giving rise to the saying "more money has been lost reaching for yield than at the point of the gun."

Because it's an active fund, MINT's investment merit largely rides on its manager's competence. If it were Paul McCulley, who was long head of PIMCO's short-term desk, MINT would be a no-brainer as far as ultra-short-term bond funds go. There was no keener observer and participant on the workings of the shadow-banking system during the financial crisis. He coined the term "shadow banking" in 2007 and identified the excesses occurring within it well before the rest of the market, helping PIMCO avoid the mines that blew up many other ultra-short bond funds and cash alternatives like SIVs.

Jerome Schneider, formerly McCulley's second-in-command, is now at the helm. Schneider doesn't have much of a public record, so it's hard to say if he's McCulley come again. But MINT isn't a one-man show; its performance in large part reflects the quality of PIMCO's committee-generated macroeconomic forecasts and its way of thinking about the world. Reassuringly, the firm has a keen appreciation of the work of Hyman Minsky, who argued capitalist economies experience endogenously created credit cycles, which are responsible for boom and bust. In Minsky's model, the character of financing changes over time, beginning with conservative hedge financing, in which borrowers can pay all their obligations with their cash flows, evolving to speculative financing, in which borrowers can meet their obligations with collateral, and finally after a long period of stability and prosperity, achieving speculative apotheosis in Ponzi financing, in which borrowers can only pay off their debts if their assets appreciate. It was through the Minskyian lens that McCulley observed the rise of Ponzi finance in the 2000s and kept out of the worst of it. Schneider almost certainly shares a similar view of the world.

PIMCO's process has worked well in the short-term paper market, judging by the performance history of its flagship ultrashort-bond mutual fund  PIMCO Short-Term (PTSHX). The fund is a bright spot in a category littered with blowups and failures. Over the 15-year period ended Sept. 30, 2013, the fund earned 3.48% annualized, beating the average fund in its category by 107 basis points with a tad less risk. The blemish on the fund's record is its late-2008 performance. The fund swiftly lost more than 4% exactly when the market was going to hell in a hand basket, whereas Treasuries and most MMFs did fine. Investors may have earned higher returns over the long run, but they did so at the cost of risk that showed up at the worst possible moment. However, once the crisis passed, the fund bounced right back. PIMCO Short-Term's performance in late 2008 is an object example of liquidity risk. To be fair, MINT likely won't court as much of it owing to Short-Term's experience, the requirements imposed by the ETF structure, and its money-market-like mandate.

MINT is a perfectly decent way to boost yield, except it is expensive. With a fee of 0.35% and a sub-1% yield, you're effectively paying 30% of gross profits to PIMCO. You can't reasonably expect more than 1% annualized returns at today's valuations. Most investors are better off putting their money in CDs or high-yielding savings accounts, which offer even higher yields than MINT.

There is a time for MINT and its ilk, but it's not now. MINT is for investors who've tapped out FDIC-insured options, are willing to bear the possibility of loss, and don't need their cash soon.

 

 

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