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A Closer Look at PIMCO's Proposed Total Return ETF

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. PIMCO dropped some big news on the market on Wednesday with a filing for a PIMCO Total Return ETF. This is potentially game-changing news for the ETF industry and ETF investors. Joining me to dig into the details from our mutual fund team is Eric Jacobson, director of fixed-income research, and from our ETF team Paul Justice, director of North American research.

Thanks for joining me, guys.

Eric Jacobson: Thanks.

Stipp: So, first question about this filing that I think it's important for investors to note: This ETF isn't going to be carbon copy of the PIMCO Total Return Fund. How might it be different, Paul?

Paul Justice: Well, it's going to show the same name, so I could see there is going to be some investor confusion likely to see the two funds next to each other, but there is going to be some differences really on the fringes.

First of all, right now in the prospectus, the ETF doesn't have the allowance to get any derivative exposure, which Bill Gross has used extensively in his other fund to make some bets because of the liquidity of those contracts. So, that's going to one difference. It's going to resemble more some of the retail versions of the Total Return Fund, which Eric knows much more about than I do.

Stipp: So, Eric, this isn't the first time that we've seen a version of the Total Return Fund. There have been other versions that have also been mutual funds. Can you explain a little bit about how those are different and how they are the same?

Jacobson: Sure. In most cases the mutual funds are run almost identically to PIMCO Total Return. In other words the investment mandate isn't usually any different. What can be different often is that because of the size, there are things that are actually a little bit easier to do in the smaller funds, so for example Harbor Bond and what I believe is now called Managers PIMCO Bond--it used to be called Fremont Bond--they've been able to do things like buy specific mortgage pools rather than use mortgage forward contracts, which are derivative type that are just much easier to use in a much larger portfolio like PIMCO Total Return.

On the other hand, you may not get quite the scale on some things, but by and large it's actually a little bit easier to run a smaller portfolio.

Stipp: Have we seen a divergent performance with some of these other funds or have they pretty much performed in line with each?

Jacobson: It's a really interesting question because over the long-term they tend to track almost perfectly and almost down to the basis point, if you will, once you factor in the expenses. However, there have been examples, particularly during problematic years like 2008, where a single security perhaps that defaulted messed up the return pattern a little bit.

We've also seen cases in which cash flows in and out of portfolios have made a difference over the years because a bond, for example, that was available at one time for one fund wasn't available at the time that an inflow came to another fund.

That's something that may or may not be a factor depending on how they manage these portfolios. They're trying to get a lot closer in terms of keeping them in parity, because it doesn't just affect those funds, it affects a lot of institutional separate accounts and subaccounts and variable annuity platforms and things like that, and people are concerned about it. The good news is, as I said, that over the long term they almost always track out within a basis point or two.

Stipp: So, Paul as you're thinking about the ETF, and I know we don't know a lot of information about it, but given the ETF structure and what they might be able to do in the ETF given how much they might be managing in that particular investment vehicle, might the ETF perform possibly better or could it perform worse than PIMCO Total Return.

Justice: Both, right? I would expect it to track very closely. I think that the overarching themes that Bill is going to invest in the Total Return are going to be similar within the ETF. Most of those macro factors would probably explain most of the performance beforehand, because Bill has been very upfront about what he's seeking out in the bond market and letting us know what types of exposures he's going to layer within the fund.

So I would expect the ETF to track very closely, though not perfectly, with the mutual fund.

Stipp: So a quick follow-up for you. One of the things with ETFs is that they have a more frequent disclosure of what's in the portfolio and this is obviously something that this PIMCO ETF would also have to comply with. Do you expect that could cause problems for an active manager who might not want to disclose all the moves that he is making on any given day, so that people could front-run him. Is that potentially a problem and could be a head-wind for the ETF?

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Justice: Well, that's been the common criticism for active ETFs. If you're going to have an active manager, they want to be able to hide some of the things that they're doing. I don't think it's going to be as big of a problem in this case. One, if you look at the Total Return Fund, there are about 12,000 holdings within there. It's not like you're going to able to front-run Bill on a whole lot of issues.

Secondly, there is already an issue in this fund with separately managed accounts with a certain amount of disclosure there on a much more frequent basis than what you'd see with a mutual fund and the ETF is going to align more with that. So, people who already want to be in the know in order to capitalize on this, they are already in the know.

Stipp: Okay. Eric, a question for you on the size of the PIMCO strategy, the Total Return strategy. It's very big. I think it's the world's biggest mutual fund as it is. So with this ETF, now they might be attracting even more assets. Do you have concerns with how big this strategy is?

Jacobson: Well, ... I'm not as concerned at the moment anyway about the ETF itself, because again it doesn't have any assets yet. I wouldn't expect it to explode to the size anytime soon that's going to be as big a factor as the fund itself already is. As you said, it's about $235 billion. PIMCO manages more than a few hundred billion in the very same style already.

Yes, the answer to that question is yes. It is something of a concern but it's not a red flag at this point per se. Concern in the sense that something we want to keep monitoring. We've been doing some research on it, looking into it, and eventually we're going to put out some of the findings there. I don't think you'd be able to say that we've seen any detriment suffered by any of the funds so far as a result. In large part, because Gross has done such an excellent job of managing these funds in a very macro way and not falling victim to liquidity issues and so forth. He's managed to circumvent markets where liquidity might become problem, when it might become a problem. The bigger question is, over the long term, will he be able to keep doing that?

Stipp: I just want to turn it over to you, Paul, and talk a little bit about what it means that this strategy is available in the ETF space as far as the distribution of the fund.

Can you talk a little bit about from an ETF investor's perspective, how is the game different now that a strategy like this is available.

Justice: I think there are two interesting points. First of all, this is a great validation for active ETFs. This is a household name. Anybody who is investing in funds likely knows who Bill Gross is and his influence on the industry, so it brings a lot of credibility to the active ETF space.

If Bill Gross is willing to do this, with more frequent, daily disclosures about what he is doing, why can't somebody else do it? He has done really well over time.

So, I think that you're going to see a lot more people say, "Okay, this is a viable strategy, perhaps we can bring our funds here."

And why would they do it? And that's the distribution portion of the question. You are not going through the supermarket areas and you're not layering on loads or distribution fees when you go to the ETF marketplace. You're going through the exchange, where everybody has a brokerage account already.

So, you are making this fund available to anyone. Not that PIMCO's had trouble attracting assets, but now they have no restrictions around that distribution channel and the all-in fees for retail investors, especially, can be much lower in that case, giving them access to great funds by great managers without worrying about being on the right platform. And I think that's the key.

Stipp: So, we don't ... know what the actual expense ratio is going to be on the ETF, but you do expect that it would be pretty low--or what is your expectation with the ETF?

Justice: Typically, what we see with ETFs is they come out more at institutional-type fees. Now, how can they do that? Let's say, Bill Gross still wants to get paid on either one of these funds. What is he avoiding? He is avoiding the fact that he has to deal with a lot of the small frequent investors. He doesn't have to do the recordkeeping. He doesn't have to pay the wholesalers, or the people that are going to distribute the funds. All of those things are taken care of on the exchanges themselves, and he is only going to be dealing directly with the authorized participants, who are going to send him cash so he can manage his funds still.

So, it really is an outsourcing of certain types of services that mutual fund companies provide when you move to the ETF structure, and I think that this is a great thing for investors overall because it may lighten the fee burden that they had to have that relationship directly with the fund company or some other intermediary.

Stipp: Eric, when this ETF comes out--we expected it will, but it's not out yet. But, potentially, it will be out soon in the near future. Certainly, there will be investors who will want to have it in the ETF structure that may already have the mutual fund. What should they think about if they were trying to decide, should I move from the mutual fund to the ETF?

Jacobson: Well, certainly, the first thing as you are implying, is that we want to take a look and see what the costs look like. I think he is right that there is a very good change that they're going to be advantageous from that perspective.

The other issue, of course, is whether or not you've got any kind of embedded tax burden. You want to get a look, and we want to take a look and see how well PIMCO does at managing some of those issues in terms of disclosure and flows.

I would expect that if anybody is going to do a good job at it, they are. They've got a lot of experience with structural issues like this, and figuring out how to make them more. So, I do think it's a really interesting litmus test for the format.

Then again, of course, the question of transaction cost as well. If you're talking about an investor who is a buy-and-hold type of investor that simply wants to move where it is sitting in an account there versus getting it into on ETF, that probably makes a tremendous amount of sense depending on whether the fees makes sense for you. But someone who is a smaller investor doing a lot of dollar-cost averaging might not benefit as much. That's true of any comparison between a fund and an ETF.

Stipp: Paul, last question for you: As an ETF investor and you're looking at your options in this space and the competitors that this PIMCO ETF might have with other ETFs. What might investors think about their ETF allocation to fixed income now that this new player is there?

Justice: I think it's been pretty common across the ETF space that people have looked at bond ETFs, and rightfully or wrongfully said, "you know what--there are some problems here. I see some tracking errors going on, I see more frequent premiums and discounts." And those issues have led them to believe that maybe bond index funds themselves aren't that good especially in the ETF format, and so they thought about using mutual funds for that portion of their allocation and ETFs for the equity side. There is this perception of more efficiency there.

Whether or not that's right or wrong is up for debate. We would say that there is actually a lot of price discovery going on in the ETF. But what it does now is allow people to say, I like active management in fixed income, but I really want to be in ETFs. This is going to allow them to get the best of both of those worlds. You're utilizing the structure properly if that's where you've found the benefits. If there was a strategy you were targeting before, you could only do it in mutual fund, and I think opening up active management in fixed income in this way is a great thing for investors.

Stipp: All right, guys--thanks for your insights on this big news. I look forward to checking in with you as this fund begins to come to market, and thanks for joining me today.

Jacobson: Glad to be with you.

Justice: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.