A Top Total Return ETF

07/30/2012 8:30 am EST

Focus: ETFs

When you're buying an exchange traded fund from one of the top bond houses in the business, you expect a top performer...and this fund doesn't disappoint, writes Timothy Strauts of Morningstar ETFInvestor.

PIMCO Total Return ETF (BOND) is an exchange traded version of PIMCO’s flagship Total Return bond strategy. The Institutional share class of the mutual fund has beaten its benchmark, the Barclays US Aggregate Bond Index, in 17 of the past 24 years, a solid 70% winning rate.

Its record puts it near the top of the bond-fund heap, and its big asset size owing to its success does not seem to have detracted from its performance: Its best year was 2009, which it started as a $136 billion fund.

Such persistent outperformance is enabled by the ample liquidity of the fixed-income markets PIMCO competes in. But it comes at a cost: Macro­economic forecasting and central bank-watching are so well-practiced by the market that the upside to doing it well is effectively capped. So don’t expect outsized excess returns. PTTRX has beaten its bench­mark by about 1% annualized since inception—and it is one of the most successful bond funds ever.

I think of BOND as a lopsided bet. If PIMCO fails to add alpha, it probably won’t hurt my portfolio too much because of BOND’s low tracking error to the index and its reasonable fees. In all, it’s a good bet, but don’t expect miracles out of this fund—US bonds are priced for atrocious returns.

BOND is a good core bond holding that focuses on high-quality intermediate-term bonds. The ETF can’t buy derivatives such as futures, swaps, and options. The lack of derivatives will limit some of the tactics employed, but it removes counterparty risk.

BOND discloses its portfolio holdings daily. This will be the first time that investors will be able to see PIMCO’s macroeconomic views in real time through the holdings of the ETF.

Although the holdings will differ between funds, PIMCO allocates shares of securities to the different funds following the Total Return strategy on a pro-rata basis. This means that the ETF will get new positions at the same time as the mutual fund.

Fundamental View
The strategy follows a top-down investment process that leans on Bill Gross and the PIMCO invest­ment committee for their secular outlook on the global economy and interest rates. The PIMCO team forecasts future interest-rate volatility, yield-curve movements, and credit trends to guide its portfolio allocation decisions.
BOND is a very new ETF, but in its short lifetime it has produced some outstanding results. From BOND’s inception to May 9, it has returned 4.28%, which trounces the benchmark’s return of 0.74%. BOND was launched right as the PIMCO Total Return strategy was outperforming the market, but it has even bested the mutual fund that follows the same investment strategy. PIMCO Total Return Institutional has returned only 1.87% over this period.

When BOND was launched with about $100 million in assets, Bill Gross was able to start fresh with a brand-new portfolio that had no legacy positions. The recent outperformance shows how a highly skilled active manager can add tremendous value in a small portfolio.

It pays to be little. PTTRX has more than 19,000 holdings, whereas BOND has just more than 300. Because the ETF portfolio is very nimble, PIMCO’s best individual bond ideas can be bought with large percentage allocations.

Effectively, the ETF is performing like Bill Gross’ “best ideas” list. In the mutual fund, if a PIMCO credit analyst finds a mispriced corporate bond, adding it to the large port­folio will have minimal effect on the portfolio’s returns. Add that same bond to the ETF, and it could make a big difference in the returns. The ETF also can make quick changes to its allocation without unsettling the market.

For example, if PIMCO wanted to reduce its allocation to emerging-markets bonds in the mutual fund to 2% from 10%, it would need to sell $20 billion of emerging-markets bonds. That’s not impossible, but it’s very hard to execute quickly. In the ETF, that same change would involve selling only $56 million in securities.

Investment-grade bonds have performed very well in the past few years, but going forward the potential for rising interest rates is a big concern. The Federal Reserve’s plan to maintain the federal-funds rate near 0% until 2014 will keep rates low across the entire yield curve for the foreseeable future, but at some point rates will rise, and when that happens the fund will likely suffer losses.

Investors should keep an eye on the Consumer Price Index for signs that inflation is picking up, because the Federal Reserve will have to raise rates if inflation rises too high.

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