Image Credit: Christophe Vorlet
By Jason Zweig | April 5, 2013 6:06 p.m. ET
Bill Gross is beating himself up—in more ways than one.
In the monthly investment outlook he released this past week, the co-founder of Pimco, who oversees $2 trillion in investments, asked: “Am I a great investor?” His answer: “No, not yet” — because, he wrote, he hasn’t been tested in a period unfavorable to bond investors.
Meanwhile, Pimco Total Return, the portfolio launched by Mr. Gross in 1987 that has long been the world’s biggest mutual fund, is being shown up badly by an upstart exchange-traded fund — which just happens to be run by Mr. Gross himself.
Even though both funds follow the same strategy, the Pimco Total Return ETF has earned 13.5% since it launched in February 2012, or five percentage points more than Mr. Gross’s original Total Return fund. In bond investing, which is a game of inches, the returns of these two funds are light-years apart.
How has Mr. Gross managed to beat himself at his own game? The small new fund allows him to be more nimble. And that is a lesson that doesn’t apply just to Mr. Gross. A big fund does have some advantages; expenses tend to be lower, for example. But as Warren Buffett has said, the manager of a small portfolio needs “only good ideas,” while the manager of a giant one needs “good big ideas” — which are much rarer. And Mr. Gross’s new ETF is a master class in how a manager can do better in a small fund than a big one.
Pimco declined several requests to comment on the two funds. But the funds’ disclosure documents and interviews with analysts suggest that Mr. Gross and his team have methodically sought to take advantage of the ETF’s small size. Launched with $100 million in assets, the ETF has grown to $4.6 billion in 13 months. The original Total Return fund, at $289 billion in assets, is more than 60 times bigger — and much less nimble.
In the older fund, building even a smallish 1% position requires nearly $3 billion — a sum that would swamp many areas of the bond market.
A 1% purchase by the ETF, however, takes less than $50 million — just right for buying bargain issues that are rarely available in vast quantities.
“When it started,” says Timothy Strauts, an analyst at Morningstar who follows the ETF, “the fund was able to swoop in on every best idea that Pimco had at that time, even if they were available only in small lots.”
So, while its elder sibling had more than 26% of its assets in government-related securities, mainly U.S. Treasurys, the ETF had just 18%, according to both funds’ year-end reports. At 10%, the ETF had twice as much in municipal bonds as the mutual fund did.
The ETF holds just under 1,000 securities — compared with more than 19,000 in the mutual fund, according to Morningstar.
“Both funds are sticking to the same mandate, but the ETF is smaller, so it can take less-liquid positions and it can take more credit risk,” says David Merkel, principal of Aleph Investments in Ellicott City, Md., who formerly ran a $4 billion bond portfolio for an insurance company.
The funds’ disclosures indicate that more than 3% of the ETF’s holdings are characterized by Pimco as difficult to price (or less liquid), nearly twice the level at the mutual fund.
Shortly after its launch, for example, the ETF bought roughly $3 million of notes issued by Trafford Centre, a British property firm. As of the end of last month, estimates Mr. Merkel, the ETF had earned a return of about 7% on these notes. They don’t appear to have been held by the mutual fund, according to its disclosure documents — probably because they weren’t available in sufficient quantity.
David Schawel, a bond manager at Square 1 Bank in Durham, N.C., was following along as the Total Return ETF got up to speed. He believes the ETF was able to buy some small lots of mortgage-backed securities below what they were worth, largely because no other buyers were interested at the time. Pimco could then mark them up to fair value on its own books, says Mr. Schawel — a perfectly legal practice that works particularly well in a small fund.
What of the future? If bonds are hit by a protracted bear market, Mr. Gross would get the ultimate test he has been seeking to learn whether he can meet his own definition of a great investor. His original mutual fund, with its greater diversification, might turn out to be somewhat safer in a bad market.
But if — as Pimco itself is forecasting — interest rates remain low for an extended period, then the ETF is likely to be the better bet for investors who want to gamble on Mr. Gross’s skills.
Source: The Wall Street Journal
http://www.wsj.com/articles/SB10001424127887323916304578404820634572846
Note: The Securities and Exchange Commission ended up contending, in late 2016, that the Pimco ETF’s technique of buying small lots of bonds hadn’t been appropriately explained to investors.
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