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 and 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 U.S.-traded 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 -- a mutual fund with a similar strategy that is sold in the United States -- had its Analyst Rating 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 for Canadians who can efficiently access U.S.-traded products.
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. The mutual fund version of PIMCO Total Return has had a tracking error of 1.6% since its inception in 1987. Most of the time PIMCO keeps tracking error much closer to 1%, 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 minimal credit losses and has in recent years behaved like a government bond 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.
According to the fund's former manager Gross, about 0.75% of Total Return's excess returns can be attributed to three structural tilts:
- short-duration credit risk (which has provided exceptional risk-adjusted returns historically);
- targeting intermediate maturity bonds and "rolling down the yield curve" to earn extra capital gains;
- 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 BOND 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, BOND'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. BOND 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 BOND.
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% 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 non-USD-denominated securities, and 15% in emerging-markets securities. The fund can also own equities and equity-like 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 non-agency 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 unitholders.
Fees
BOND charges a 0.55% expense ratio. 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 exposure to strategies and asset classes that are hard to replicate with passive options.
