Still Excellent Without Bill Gross

September was bad for  PIMCO Total Return ETF (BOND). On Sept. 23, 2014, The Wall Street Journal reported that the Securities and Exchange Commission was looking into whether PIMCO had been artificially boosting the exchange-traded fund's performance by buying small, illiquid mortgage bonds at discounted prices then valuing them higher using outside pricing services. Later that week, on Sept. 26, PIMCO co-founder Bill Gross announced he would be decamping to Janus. PIMCO hastily promoted Dan Ivascyn to "group chief investment officer" and announced that existing PIMCO managers Mark Kiesel, Mihir Worah, and Scott Mather would take over the Total Return strategy, including this ETF.

Gross' departure came just eight months after then-CEO and heir apparent Mohamed El-Erian unexpectedly resigned. The two were the dominant personalities on PIMCO's Investment Committee, the body that determines the broad risk exposures of the firm's strategies. However, Ivascyn and other members of PIMCO's Investment Committee are longtime firm veterans and well-regarded. Ivascyn said he expects the firm's committee-driven process to remain intact, including the quarterly cyclical and annual secular forums it convenes to determine the firm's macroeconomic forecasts.

Although Morningstar does not assign Morningstar Analyst Ratings to ETFs,  PIMCO Total Return's (PTTRX) was downgraded to Bronze from Gold in the aftermath of Gross' departure. Bronze is our lowest-conviction positive rating, but it indicates that Morningstar believes the fund will outperform its category peers on a risk-adjusted basis over a full market cycle. Morningstar also maintains a positive view on the quality of the fund's new portfolio managers and its existing investing process, which is unlikely to change significantly. BOND remains a fine core bond fund.

BOND is run in a very similar style to the PIMCO Total Return mutual fund. Both combine PIMCO's macroeconomic views with security selection and, in theory, are allocated many of the same active bets pro rata. BOND beat its mutual fund sibling by more than 3% in its first three months in early 2012. During that time, the weekly return correlation between BOND and PTTRX was only 0.76. Since then, BOND's performance advantage has moderated (but not fully dissipated), and its weekly return correlation to BOND has risen to about 0.96. PIMCO believes BOND will more closely track the mutual fund in the future.

Fundamental View
PIMCO tightly manages the Total Return strategy's tracking error against its benchmark, the Barclays U.S. Aggregate Bond Index, a proxy for taxable, U.S.-dollar-denominated, investment-grade bonds. Tracking error is defined as the standard deviation of the differences in returns between a portfolio and its benchmark. PIMCO Total Return's tracking error since its inception in 1987 is 1.6%. Most of the time PIMCO keeps tracking error much closer to 1.0%, ramping up its bets dramatically when it has a high-conviction call, such as in 2008 and 2011.

PIMCO attempts to beat its benchmark by making duration, sector, currency, credit, country, and volatility bets. Many of the securities and derivatives PIMCO uses are not contained in the benchmark.

As of this writing, the Barclays U.S. Aggregate Bond Index yields a little more than 2%. Starting yield is an excellent long-term predictor of high-quality bond performance. Historically, the Aggregate Index has experienced de minimis credit losses and has in recent years behaved like a Treasury portfolio with some credit risk. PIMCO aims to add about 1% over this after fees, for a total nominal expected return of 3%.

Because of the multitude of tools at its disposal, PIMCO has been able to capture many different return streams and earn steady excess returns. Since inception, PIMCO Total Return has beaten its benchmark by a little more than 1% annualized, for an excellent information ratio (defined as excess return over annualized tracking error) of about 0.67.

According to the fund's former manager Gross, about 0.75% of Total Return's excess returns can be attributed to three structural tilts: 1) short-duration credit risk (which has provided exceptional risk-adjusted returns historically), 2) targeting intermediate maturity bonds and "rolling down the yield curve" to earn extra capital gains, and 3) selling volatility through option sales and "bulleted" portfolios. However, in the past decade, 74% of Total Return's excess returns have come from "factor timing," a polite name for market-timing, according to an analysis by PIMCO portfolio manager Mihir Worah. In this period, much of PIMCO's outperformance came in late 2008 to early 2011, in large part driven by mortgage-backed securities it had bought during the depths of the crisis.

Because PIMCO Total Return earns part of its keep by taking on more volatility and credit risk, the fund is biased to underperform when markets fall or when interest rates unexpectedly move, unless the firm has correctly anticipated these movements. In the years since the financial crisis, Total Return's active bets picked up quite a bit. It felt good when things were working, but in 2011, PIMCO made a disastrous bet against U.S. Treasuries, anticipating rising rates when the second round of the Federal Reserve's quantitative easing was to end. Total Return has since clamped down on its active bets, and tracking error has reverted back to historical levels.

According to PIMCO's "New Neutral" secular forecast, unveiled in May, interest rates, inflation, and growth will remain low for a long time, meaning bonds and stocks look fairly priced. As a consequence, PIMCO has ramped up allocations to credit sectors in many of its strategies, including Total Return.

Portfolio Construction
As of the end of September, BOND has an estimated yield to maturity of 3.6%, considerably higher than the index's 2.0% yield. This yield is associated with an effective duration of 5.25 years, slightly lower than the Aggregate Index's 5.29-year duration. According to its prospectus, BOND will keep its duration within two years of the benchmark's, and it may invest up to 10% of its total assets in junk bonds rated B or higher, 30% in foreign-currency-denominated securities, and 15% in emerging-markets securities. The fund can also own equities and equitylike securities with up to 10% of its assets. The fund can now invest in derivatives, a restriction that was recently lifted by the Securities and Exchange Commission. BOND uses its latitude to own nonagency mortgage-backed securities, junk bonds, and Treasury Inflation-Protected Securities. It has a small net short position in cash, indicating that it is somewhat leveraged in the financial sense, but this number can over- or understate the fund's true economic riskiness. Despite substantial outflows in all Total Return-related strategies, which have quickly moderated, most of the markets that PIMCO trades in are highly liquid and replicable with many different instruments. While there was some pressure on PIMCO's big positions by traders anticipating redemptions, we do not expect outflows to harm long-term shareholders.

Fees
BOND charges a 0.55% expense ratio, 0.09 percentage points higher than the Institutional shares of PIMCO Total Return but still much lower than the fund's A and D share classes. BOND is a better option than most of PIMCO Total Return's noninstitutional share classes. If PIMCO maintains its historical 1% excess return, PIMCO's fee as a percentage of gross excess returns is about 30%. Economically, investors pay more than the 0.55% expense ratio. Bonds, for example, usually aren't sold with explicit commissions. Broker/dealers generate revenues through the bid-ask spread, the difference between the prices at which they're willing to buy (the bid) and sell (the ask) bonds. Bid-ask spreads for less-liquid bonds can be much bigger than the explicit commissions that equity investors pay. Investors also pay for swaps, which are also not reported in the expense ratio. Index funds also pay implicit costs beyond the expense ratio, though the exact magnitudes of such costs are hard to estimate. BOND is expensive by ETF standards, but it also offers exposures to strategies and asset classes that are hard to replicate with passive options.

Alternatives
Investors are no doubt pondering whether to stick with PIMCO's flagship strategy after Gross' departure. A natural alternative is simply to own the benchmark. The biggest fund tracking it is Vanguard Total Bond Market Index, which charges 0.20% for its Investor share class ((VBMFX)) and 0.08% for its ETF share class ((BND)). The Vanguard fund tracks a float-adjusted version of the Aggregate Index that removes from consideration bonds held by the government. IShares Core U.S. Aggregate Bond (AGG) is the second-biggest ETF tracking the index and also charges 0.08%. Both funds behave almost identically, but the Vanguard fund owns much more of the index's underlying securities. Despite PIMCO Total Return's publicized woes, as of Sept. 30, BOND has beaten its benchmark since inception, over the trailing year and for the year to date.

For investors seeking the potential for excess returns, the total-return mandate run by Tad Rivelle's team at Metropolitan West is a good option. The team runs  Metropolitan West Total Return Bond (MWTIX) and  TCW Total Return Bond (TGLMX). The two are not exact clones but offer similar exposures and return potential. The MetWest fund has a Morningstar Analyst Rating of Gold, while the TCW fund is rated Bronze. They charge 0.45% and 0.49%, respectively, for their Institutional shares. Rivelle favors mortgage-backed securities, particularly those not backed by government guarantees. His substantial stake in the sector has helped drive outperformance during the past several years.

 

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