PIMCO Total Return: Not Fussing

Putting Into Perspective
The kerfuffle over PIMCO--and its signature fund,  PIMCO Total Return (PTTRX)--continues. Following The Wall Street Journal's Feb. 24 expose of the company's personality conflicts among upper management, which led to the departure of chief investment officer Mohamed El-Erian, have been several articles, including one from today, basting the wound with salt. El-Erian and PIMCO founder Bill Gross are apparently feuding, and PIMCO's mutual fund cash flows were poor in February.

The first is unsurprising, and the second is overstated. I would scarcely expect El-Erian and Gross to be chummy at the moment (although I suspect that over time the annoyances will cool and they will ultimately become cordial ex-colleagues). As for those February cash flows, they've been weak for several months now at PIMCO and surely were little affected by a story that broke with only two trading days left in a month.

The commotion reminds me of the postshow discussions of The Bachelor, with recriminations flying over Juan Pablo's appalling behavior. Or, to move up in literary merit, the B plots of Shakespeare's tragedies. Bill Gross proclaiming to PIMCO's traders that he is Secretariat--a juicy detail of the original Journal article--is Falstaff mimicking the actions of Prince Hal. With due respect to Gross, he is neither a sports champion nor a tragic hero. He is somebody who buys and sells bonds.

And, the truth is, how well he buys and sells bonds is not particularly critical to most of his funds' investors. Yes, PIMCO's success or failure means much to institutional managers or consultants who are evaluated by the basis point, and perhaps to advisors who have clients questioning why their assets are in the bond funds of a company that currently is getting bad press and generating mediocre numbers. But the overall effect on a typical investor's portfolio is minimal.

Consider, for example, an investor who 10 years ago had $500,000 in a tax-sheltered account. She placed $250,000 into  Vanguard Total Stock Market Index (VTSAX), $125,000 into a money market fund that gained 1.50% per year, and $125,000 into PIMCO Total Return's Institutional shares. Without rebalancing, that investment would be worth $907,312 today. Had our hypothetical investor held the same portfolio, but instead of PIMCO's fund purchased the unmanaged Barclays Aggregate Bond Index (for example,  Vanguard Total Bond Market Index (VBTLX)), the portfolio would be worth $877,678. That's 3.3% less on the final investment--not exactly a life-changing amount.

That difference required 10 years of compounding, a large 25% stake in a single PIMCO bond fund, and the foresight to select a fund that would create a performance gap by beating 96% of its competitors. Over the next 10 years, PIMCO Total Return is unlikely to perform as spectacularly (in either direction), so the effect of owning it rather than either a bond index or another mainstream bond fund is likely to be even less than the 3.3% given in the above example.

Or, our investor could have made a modest change in asset allocation and placed 60% of her assets into the stock fund, with 20% each into the bond index and money market fund. That portfolio would now be worth more than the original portfolio, at $917,836. The additional 10 percentage points in stocks would have been more important than selecting the champion bond fund.

The asset-allocation competition is that close only because stocks have fallen relatively in line with bonds over the decade. Over the past five years, the very modest switch into a 54/23/23 allocation would have comfortably placed the bond-index portfolio past the 50/25/25 PIMCO Total Return portfolio.

As for the notion that selling pressure caused by redemptions could harm PIMCO Total Return's performance by forcing it to dump illiquid securities at a discount, the fund is laden with Treasuries, Treasury Inflation-Protected Securities, and government mortgage-backeds. Losses from forced trades are a legitimate concern with bond funds, as evidenced by the collapse of Schwab YieldPlus in 2008, but even if PIMCO Total Return is whacked with massive redemptions--which seems unlikely to me, as the fund's 2014 is respectable if not scintillating, hovering within a few basis points of the category average--it should be relatively immune.  

Admittedly, the same does not hold true for all the company's fixed-income funds. Some of the smaller funds invest in more-specialized merchandise and would more rapidly be squeezed by investor sales. While today's bond market is in a much happier place than were credit-sensitive bonds in 2008, one still wouldn't wish to test its ability to absorb strong selling pressure.

None of this is to be mistaken for a buy opinion on PIMCO Total Return. The fund's five-year returns are barely above the category average; PIMCO has yet to demonstrate that it can significantly outperform an index when running a fund of such immense size; and of course the concerns about management stability and Gross' succession plans remain. Those are scarcely compelling reasons to buy the fund. Holding it, as I indeed do in my 401(k) account, is another matter. No big deal.

Say What?
Felix Salmon of Reuters would maintain that my hypothetical example of investing in the Barclays Aggregate Index is just that. According to Salmon, PIMCO Total Return does not face competitive pressures from index funds because "there is no simple way of investing in bond indexes." That is a puzzling statement. Vanguard Total Bond Market Index, to cite one prominent example, tracks the Barclays Aggregate Float Adjusted Index, and very accurately at that, placing within a few basis points of the index over the trailing three-, five-, and 10-year periods. 

As with stock managers, Gross must not only outrace his flesh-and-blood competitors but also beat the mechanical horse.  

For another take on PIMCO, see tomorrow's Fund Spy.

Addendum
PIMCO, understandably, disputes my statement that "PIMCO has yet to demonstrate that it can significantly outperform an index when running a fund of immense size." That is because over the trailing years PIMCO Total Return has significantly outperformed the only index fund mentioned in this column, Vanguard Total Bond Market.

Fair enough. That's not what I meant, but the passage certainly does read that way. Let me try again, less compactly.

The Barclays Aggregate Bond Index, upon which the Vanguard Total Bond Market is based, is but one bond index. It happens to be by far the most popular bond index and is the one against which intermediate-term bond funds like PIMCO Total Return are commonly compared, but it is a very poor benchmark. For the most part, intermediate-term bond funds invest very differently from the Barclays Aggregate Bond Index. For example, in 2009 the Aggregate Index gained 5.9%, while the average intermediate-term bond fund was up more than 13%.

So, without question, PIMCO Total Return can beat a misfit benchmark (and trail it, too). The question is, How does the fund fare against a better benchmark?

There, I don't know. By Morningstar's calculations, the Barclays Credit Index is the "best fit" per a statistical regression for PIMCO Total Return, and that index has beaten the fund over the past five years. But the Credit Index is not a perfect match, either, and I would no more seize upon its five-year victory as evidence of PIMCO Total Return's failure than I would seize upon the Aggregate's  loss as evidence of the fund's success.

As I wrote, the issue remains unsettled. Also, as with yesterday's comments, these views are my own. They come after discussions with Morningstar's PIMCO analysts, but they will not necessarily match the analysts' conclusions.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.